Reinforcing Benefits Of Total-Return Investing

The Reserve Bank’s cutting of official interest rates to a record low of 2 per cent should reinforce to income-focused investors why the concept of total-return investing makes sense.

In short, total-return investing involves investing for both cash flow and capital appreciation.

And under a total-return approach, investors needing more income to finance their lifestyles than generated by their portfolios draw down against their portfolio’s capital appreciation.

By taking a total-return approach, investors should be less tempted to chase yields by reducing exposure to high-quality fixed income and broad share portfolios to increase their allocation to higher-risk bonds and more concentrated high-yield share portfolios.

Unfortunately, not all investors would recognise the higher risks involved when moving away from carefully-constructed and diversified portfolios with asset allocations that reflect their personal tolerance to risk and their long-term goals.

Following the Reserve Bank’s latest rate cut, it is worth revisiting a Vanguard research paper, Total return investing: An enduring solution for low yields, published in late 2012.

The paper points out that income-orientated investors have three fundamental choices when yields are historically low: spend less, reallocate their portfolio to higher-yielding investments or spend from total returns instead of income alone.

As the authors – Vanguard analysts Colleen Jaconetti, Francis Kinniry and Christopher Philips – say, "spending less is generally not a desirable option for most investors".

Regarding any temptation to reallocate a portfolio to higher-yielding investments, Jaconetti, Kinniry and Philips write:

Investors who shift some of their fixed-income portfolio into higher- dividend shares carry the risks of high volatility and potential for significant capital loss. "Clearly, for an investor who views fixed-income as not just providing yield but also diversification, dividend-paying stocks fall well short".
High-yield bonds are both more highly correlated with the equity markets and more volatile than investment-grade bonds.

A critical role of quality bonds is to act as portfolio diversifier or ballast for a portfolio – not solely to produce income. This should not be overlooked in a very low interest environment.

Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia.

As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment.

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