INSIGHTS

IMPLICATIONS OF A 3% WORLD – A TOTAL RETURN APPROACH

Michelle Perkins, 22 September 2016

Investors have been enduring a low interest rate environment since central banks across most developed countries slashed rates in an effort to stimulate growth following the global financial crisis in 2007/08. Eight years on, this environment is well entrenched as major economies continue to grapple with subdued economic growth, low inflation and elevated levels of both government and household debt.

The harsh reality of lower interest rates is that investors who have been reliant on the income stream generated by their portfolio are in a situation where this income may be insufficient to meet their requirements. Additionally, in a search for yield, investors may have unknowingly increased the risk profile of their portfolio and the probability and degree of potential capital loss in a down market.

Based on our observations, the key ways in which higher yields have been achieved include:

  1. Taking more credit risk in bonds by ignoring high quality ‘vanilla’ bonds where yields are seen as too low;

  2. The tilting of portfolios towards growth assets (equities/shares) where yields have been higher than fixed income over recent times; and

  3. Shifting money from high quality lower yield names to low quality – higher yield names/sectors (both in the income and growth parts of portfolios).

Together we call these three mistakes the ‘stretch for yield’. In a rising market it is easy for investors to become complacent and to ignore the risk associated with such strategies.

With the outlook for inflation and economic growth (key determinants of interest rates) remaining subdued, those investors not willing to put their capital at risk by increasing their exposure to higher yielding investments/assets have a number of alternatives to consider:

  1. delay retirement/re-enter the workforce;

  2. reduce spending; or

  3. use the portfolio’s total return as a source of spending rather than income alone.

For many, options one and two are not possible.

A total return approach

Rather than thinking about the returns from your portfolio – share price movements (capital gains) and interest and dividends (income) – as two separate components, another approach is to view the total return (capital gains and income) of the portfolio as a pool of income available to be drawn on.

This approach does not mean the way you invest needs to change. It does not mean that you focus solely on high growth companies that do not pay a dividend. Nor does it mean you shift some or all of your fixed income allocation to growth assets. What it does mean is that you can continue to maintain a well balanced and diversified portfolio of both income and growth assets that matches your tolerance for risk. The income generated from the portfolio would still be used to meet obligations, with capital gains/capital used to supplement this income.

A focus on total return also allows for long-term certainty of capital and a growing income stream as it shifts an investor’s focus from companies that may be distributing 100% of profits to shareholders and thus paying a higher dividend, towards companies with good growth opportunities that may have a lower dividend but better growth prospects. While we understand the importance of income to many investors, a focus on high dividend paying stocks at the expense of those companies that pay sustainable and growing dividends can impact the performance and level of income generated by a portfolio in the long-term.

This article was originally published in the August 2016 issue of News & Views.