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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.

 

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