In seeking to generate income from a portfolio, there are two broad approaches to consider: a traditional income-focused approach and a total return approach. This blog makes the case for a total return approach for income-seeking investors, looking at the key considerations through the lens of pros and cons.
How does a total return approach differ to a traditional income-focused approach?
Considering a traditional income-focused approach to begin with; this is an investment approach that prioritises income generation from a portfolio, seeking to produce income through dividends, interest, or coupons, and distributing this income to fund portfolio goals (typically retirement spending).
On the other hand, a total return approach uses a combination of both income and capital gains to provide for a portfolio’s distribution requirements, rather than relying purely on income alone.
What are the advantages of a total return approach?
There are a range of advantages for income-seeking investors from utilising a total return approach rather than a traditional income-focused approach.
The first point to consider is diversification. Portfolios built using a total return approach have the flexibility to invest in a diversified manner across asset classes, rather than being obligated to focus on high income-generating areas and having to rule out lower-income assets.
This leads to benefits in terms of portfolio performance; as higher-yielding assets may not represent the best potential investment opportunities at a given point in time, the flexibility of the total return approach means that a portfolio can be built to deliver the highest expected performance in line with the relevant capacity for risk. This is particularly relevant over the long term, with total return portfolios typically in superior position to preserve real value, as opposed to traditional income portfolios, which focus on higher yielding sectors which might deliver less in terms of capital growth.
It also leads to potential risk-reduction benefits; as total return portfolios are more diversified, by their nature they are less concentrated in a small number of assets or sectors, in which the assets themselves might be riskier in nature. For example, traditional income-focused investors have historically been overexposed to higher income equity sectors such as energy and financials, and higher yielding bond types such as junk bonds. The more concentrated nature of traditional income portfolios can lead to greater volatility and reduced resilience to market shocks, as well as potentially greater inherent risk from the underlying assets (such as higher risk junk bonds, or high-yielding stocks paying an unsustainable yield and therefore exposed to potential price revaluations). Additionally, portfolios reliant on fixed-income investments such as bonds can find them exposed to the risk of inflation outpacing the return received on the underlying assets, compared to a total return approach which typically has greater exposure to assets that are likely to generate a return in excess of inflation.
Alongside this, a traditional income-focused approach can lead to issues in terms of income consistency. Income from dividends can be volatile and isn’t guaranteed – for example while UK dividends rose 8% over the 2022 calendar year, they had previously fallen 42% over the 12 months to 31 March 2021 as two thirds of UK companies reduced or eliminated their dividends in response to the Covid-19 pandemic. An income-focused investor relying heavily on dividends is highly exposed to the developments and gyrations in corporate dividend markets globally.
What are the disadvantages of a total return approach?
As we all know, free lunches are quite rare in life, there are some potential tradeoffs or disadvantages to income-seeking investors adopting a total return approach.
The first to mention is of course the risk of being forced to sell investments that have fallen in value, in order to provide the required level of income. However, by investing across a broad globally diversified basket of assets, overall returns from the portfolio should be enhanced, with lower expected volatility. Alongside this there is the risk of distributing a larger amount of income than the portfolio is able to support, and therefore stricter discipline is required in terms of making distributions from the portfolio. One approach to guarding against this and preserving the real value of the portfolio is to limit distributions to the portfolio’s excess return generated above inflation, and to put a strong framework in place to maintain portfolio distribution discipline.
Finally, there is the question of how to provide distributions in years of negative returns. One approach to guard against this is to build a capital buffer, to help fund distribution needs during down-years. Building a reserve of unspent capital in this manner can help fund income needs during leaner times.
While there are pros and cons to income-seeking investors adopting a total return approach over a traditional income-focused approach, and while each individual situation is unique with its own challenges and complexities, we believe the broad advantages of total return approach outweigh the disadvantages.
Investors utilising a globally diversified total return orientated portfolio in order to achieve strong risk-adjusted returns over the long term are well positioned for capital growth and income-generation, and through prudent management, the income generating capacity of such a portfolio can be maintained over the long run.
Alongside accumulation share classes, ebi provides access to our portfolio range through income share classes, for those investors who wish to generate income from their portfolios while maintaining a total return approach.
Blog Post by Jonathan Griffiths, CFA
Investment Product Manager at ebi Portfolios.