Rethinking income investing
A total return approach can help generate income from a portfolio, while providing greater investment flexibility.
Generating sustainable income from investments has been a challenge for much of the past decade. Covid-19 has made it even more problematic. With central banks set to keep policy interest rates at zero – or lower – for the foreseeable future, government bonds are likely to continue yielding very little. The income outlook is also difficult in equities. Many traditional income sectors have been forced into dividend cuts – either by the pandemic or the need to adapt their business models.
There has been a long-held view that income generation should be “organic.” In other words, it should come from the dividends on equities and the coupons on bonds. According to this view, taking income from capital risks “pound cost ravaging” – where capital is sacrificed to create income, making it harder to create income in future. However, in today’s environment, focusing solely on income is potentially more damaging.
This is particularly the case in the new pensions environment, where clients may remain invested for longer, but where significant drawdowns in capital could irreparably reduce a client’s income prospects in retirement. Pensions have also become an important inheritance tax planning tool and as such, there may be an imperative to preserve as much of the pension pot as possible.
The benefits of total return
Total return investing provides much greater flexibility. Under this approach, both income and capital are used to make distributions. This enables investors to focus on achieving the best performance overall - rather than on investments which will give the "right" balance between capital growth and income.
This flexibility has proved its value in recent years. A focus on income would have significantly restricted an investor’s universe – causing them to miss out on many of the opportunities that have been driving global markets in recent years, such as US technology. Many of the most successful companies in the sector pay no dividends as they re-invest in their businesses.
Focusing on income-generating sectors can in fact introduce extra risk into a portfolio. An income focus would likely have led investors to a focus on “value” sectors, which tend to offer more attractive yields. However, many of the companies in these sectors are perceived to have limited growth opportunities and have fallen out of favour in an “age of disruption.” UK income investors have traditionally tended to stick to their home market, which offers a higher yield and more of a value tilt than global market. This would have come at a heavy cost last year. In 2020, the UK equity market fell 9.8%, compared to global equities which returned 12.9% in sterling terms. We believe that technological disruption is set to continue and do not believe that investment portfolios should be limited or biased towards a narrow income universe.
Beyond equities and bonds
A total return approach provides the flexibility to further increase diversification by accessing alternative investments that may provide no income but can improve the risk-adjusted returns of a portfolio. An example would be gold, which provides no income but can provide a level of protection against market volatility. Ultra-low interest rates reduce the relative cost of holding gold versus bonds, while gold can also be a useful hedge against geopolitical and inflation risks.
Of course, alternatives can also be a source of income. We offer exposure to a wide range of specialised investments including infrastructure, aircraft leasing and music royalties through the Diversified Alternative Asset Fund. The portfolio provides an uncorrelated, diversified source of both income and capital growth.
At a time when the suitability of client risk profiles is under increasing scrutiny, it is important to ask whether a portfolio that restricts flexibility and relies on a traditional income approach remains appropriate. Neglecting capital growth in favour of the pursuit of income risks losing sight of the client’s real goals. Importantly, there are no tax constraints in a pension environment, making it even less important where return comes from.
Total return should be the priority for those investors looking for long-term income without compromising capital.
Richard Gould joined in 2007 and is a Private Client Director within the DFM Team. Richard began his career in the City working for an executive search agency focusing on asset management firms. He then moved to Morley Fund Management where he worked on the Corporate Bond team before moving to the Private Equity desk. Richard has completed the Chartered Securities and Investment Institute Masters in Wealth Management. Richard has 10 years’ investment experience.
This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.