Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 344

The pitfalls of total return investing

In a former life, as a financial planner, I counselled my clients to consider the benefits of Total Return Investing (TRI). Forget about income, I said. Trust the academics, and the professionals (me). Today, however, I’m not so sure. TRI may in fact be doing investors a disservice. I say that because the global investment landscape has changed, and so have the risks.

The TRI theory holds that investors should build and learn to live off the total return of their portfolio, not just the income. In practice, this means investors sell appreciated assets when they need income above what is generated by the portfolio. And, where possible, live off dividend and interest income in the years when the portfolio declines.

The Total Return approach is elegant, it makes intuitive sense, and like so many investment strategies, it ‘backtests’ well – that is, it’s done well in the past. There is, however, a fly in the ointment: the prevailing global low-to-no interest rate regime. The backtests in the U.S. occurred during periods when both stock and bond yields were much higher.

5-Year U.S Treasury yield (1963-2019)

Thus, the TRI theory is based on what we now know to be the luxurious presumption of earning income from fixed interest. No one has had the experience of funding a 30+ year retirement through a period of zero or even negative interest rates.

The short income squeeze

This lack of income is a critical weakness of TRI theory because the less income your portfolio generates, the more you are exposed to the pain of calling on your principal during market drawdowns - what I term a “short income squeeze risk”.

Here’s how it works: in the event of a market downturn, a lack of income creates, in essence, a short-squeeze situation. Retirees have no choice but to sell their investments and often at times when valuations dictate they should be buying or at least holding.

To date, this danger has been easy to ignore because returns have been strong and volatility relatively benign. However, there are reasons to believe it may not be in the future.

The new risk hierarchy - consistency of income trumps portfolio volatility

Intelligent investors think in terms of risk and then return, so it may be helpful to rephrase the issue in terms of a hierarchy of risk. In the past, the risk of an income squeeze could be easily subordinated to the risk of portfolio volatility because income was readily available. Today’s environment calls for a rethink.

I contend that below a certain portfolio income threshold, maintaining a steady income is a higher priority than minimising volatility. This threshold will depend on several factors which may include:

  • the degree of spending flexibility
  • capital risk relative to income 
  • diversification considerations, and
  • other sources of funds.

The degree of capital risk assumed relative to income obtained is also a critical consideration. Investors and their advisers should examine this new retirement risk landscape and re-calibrate their portfolios if necessary.

Sustainable income – mitigating income squeeze risk

One strategy to mitigate income squeeze risk is to increase the portfolio allocation to investments that offer sustainable dividends. Specifically, companies and credits with stable business models that rely on secular growth trends, such as population growth both in Australia and abroad.

The classic rejoinder to such advice is that it entails foolishly 'reaching for yield', i.e. unknowingly increasing risk by moving from lower- to higher-risk assets. And it is true, increasing your allocation to riskier assets will raise the volatility of your portfolio.

However, the paradoxical world created by low-to-no interest rates means that the income generated by equity-like dividends may come to be the only way to shelter retirees from an income squeeze. And as a result, spare them from having to erode their principal during a severe or even moderate downturn.

Thus, it can be argued that by taking more risk, you are making the conscious decision to reduce income risk (the income squeeze). The choice then is not a reach for yield but the inevitable by-product of all investment decisions, the exchange of one type of risk for another.

Recognising this, Legg Mason has created income solutions like the Legg Mason Martin Currie Equity Income and Legg Mason Brandywine Global Income Optimiser which are designed to invest in assets that hold out the prospect of providing sustainable income. As central banks continue to consign investors to a world without income, we believe these strategies will play an increasingly important role in clients’ portfolios.

 

Peter Cook is a Senior Investment Writer at Legg Mason Australia/NZ, a sponsor of Firstlinks. This article contains general information only and should not be considered a recommendation to purchase or sell any particular security. Please consider the appropriateness of this information, in light of your own objectives, financial situation or needs before making any decision.

For more articles and papers from Legg Mason, please click here.

 

7 Comments
J.D.
February 14, 2020

The concept of total return investing is not to "live off dividend and interest income in the years when the portfolio declines".

If you had say 60% stocks and 40% bonds, then when the stock market declines, you do not live off dividends.


First you take from bonds what you need to live off. Secondly you reinvest the dividends buying socks when they are cheap. Thirdly you further rebalance from bonds into stocks also purchasing stocks cheap.

There's a common misconception amongst lay people that dividends are somehow safer than selling down shares and therefore dividends can provide reliable income. This is a fallacy. A dividend is literally a withdrawal. It's not similar to a withdrawal, it's an actual withdrawal.

Here's how it works at a company level - after a company pays out wages, debts, and other obligations, it pays out a portion of the remaining profit as dividends.

If a company worth $99M is gifted $1M, their new value is $100M.
In the same way, when a company pays out $1M in dividends, their new value is worth $1M less.
When you don't reinvest your dividends, you have a made a withdrawal.

Taking dividends is literally no different to a portfolio withdrawal, and when you take the dividends from high dividend stocks, you have made a larger withdrawal, which exacerbates the problem when there is a stock market decline.

It is absolutely shocking to me that someone who was a financial advisor doesn't know all of this.

Dudley.
February 18, 2020

"when you take the dividends from high dividend stocks, you have made a larger withdrawal":

... which enables withdrawal of tax credits from ATO, both of which can be 'deposited' to earn again.

J.D.
February 20, 2020

Franking credits are largely priced-in (see the below link for an explanation of what that means)
https://www.passiveinvestingaustralia.com/franking-credits-how-much-more-are-you-really-getting

Besides that, there are drawbacks to focusing on dividends.
1. Dividends are taxed while you're receiving your full-time salary - and at your highest tax bracket, potentially even pushing you into a higher bracket. You can't elect to delay realising gains until after you've retired where your returns would be taxed at time when you have no other salary.
2. Dividends miss out on the massive benefit of the 50% CGT discount.
3. Franking credits may be gone in the future.
4. Chasing yield is risky. It deters people from diversifying internationally leaving you over exposed to an isolated economic crisis. Also, since your income and job security are tied to Australia, by not diversifying internationally you increase the risk of your income and investments going down together. You also miss out on improved risk-adjusted returns from investing globally.

Kim Wilkinson
February 13, 2020

Adopting a "Bucket" strategy (https://www.superguide.com.au/accessing-superannuation/bucket-strategy-solution-retirement-income-plan) would seem to minimise the "low income risk squeeze".
In Australia, if the investment income drops, people have the age pension to take up (or increase).

Michael
February 13, 2020

Income from fixed interest and cash is VERY different to 'income' from equities. Dividends reduce your investment capital when they are paid (i.e. the share price reduces by the value of the dividend on the opening of the market on the ex-div date). This means that dividends and selling the equivalent value of shares are equal except for the tax implications (capital gains discount, franking credits).

Your challenge to TRI theory relies on the idea that dividends do not reduce your capital whereas selling shares does. This is incorrect. It will still be best practice for investors to choose investments for their total return potential rather than relying on only those that pay dividends at a certain level. To fund their income needs they then should sell assets and do so at all stages of the investment cycle.

Andrew Bird
February 13, 2020

I agree that a TRI approach is almost essential these days given low yields. But I am not sure I agree that piling into the very crowded "high yield" trade is going to provide the best risk/return outcome.

A simpler way to deal with the "short income risk squeee" that you mention is to keep a good cash buffer rather than compromising the growth potential of your portfolio. To use a simple example, If we assume a 5% drawdown rate on a portfolio, by keeping 15% in cash you have 3 years of income up your sleeve even without any income yield at all. Three years should be enough time to cover some pretty bad market downturns.

The 15% cash is not going to generate much but it does provide a lot of piece of mind. And the rest of the portfolio can be invested with total return in mind rather than a excessive focus on yield.

Andrew Bird
February 13, 2020

I agree that a TRI approach is almost essential these days given low yields. But I am not sure I agree that piling into the very crowded "high yield" trade is going to provide the best risk/return outcome.

A simpler way to deal with the "short income risk squeeze" that you mention is to keep a good cash buffer rather than compromising the growth potential of your portfolio. To use a simple example, If we assume a 5% drawdown rate on a portfolio, by keeping 15% in cash you have 3 years of income up your sleeve even without any income yield at all. Three years should be enough time to cover some pretty bad market downturns.

The 15% cash is not going to generate much but it does provide a lot of piece of mind. And the rest of the portfolio can be invested with total return in mind rather than a excessive focus on yield.

 

Leave a Comment:

     
banner

Most viewed in recent weeks

How to enjoy your retirement

Amid thousands of comments, tips include developing interests to keep occupied, planning in advance to have enough money, staying connected with friends and communities ... should you defer retirement or just do it?

Results from our retirement experiences survey

Retirement is a good experience if you plan for it and manage your time, but freedom from money worries is key. Many retirees enjoy managing their money but SMSFs are not for everyone. Each retirement is different.

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Fear is good if you are not part of the herd

If you feel fear when the market loses its head, you become part of the herd. Develop habits to embrace the fear. Identify the cause, decide if you need to take action and own the result without looking back. 

Latest Updates

Economy

The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.

Shares

Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.

Shares

The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.

Property

The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.