Income investing, the practice of constructing portfolios to target a specific yield, is popular, not least because, historically, high yields meant it was easy to construct a portfolio that generated a good income.
It’s also popular due to investor psychology and something we refer to as the unit fallacy.
Retiree and trustee concerns about running out of capital are entirely rational – it is after all the biggest risk to any person, trust or endowment that relies on their investment portfolio. However, there is a tendency amongst investors to confuse the number of units they hold (number of shares or number of units in funds) with their capital and this fallacy biases them towards narrow income investing and away from total return investing in subtle ways.
Partly this is a lack of awareness that receiving dividends, whilst it may not affect the number of units/shares held, does eat into remaining capital as the price of units/shares will fall just after a buyer becomes ineligible for the dividend. The same is true of bond prices. Dividends and bond coupons aren’t free – they come out of capital.
The unit fallacy also makes selling units seem painful as there is a belief amongst investors that they own a fixed number of units/shares and thus selling shares or units must necessarily mean they are eating into their capital.
This is a powerful fear, but it is misplaced as depleting capital is far less linked to selling units than one would think. Because shares can split and units can be traded fractionally, the number of shares or units held by itself is largely irrelevant – it is only when combined with price per unit that one gets an accurate idea of capital remaining. Or in other words, it’s perfectly possible for the number of units to fall, but overall capital to increase if each unit’s price grows sufficiently.
The challenge of income investing today
Yields have been falling since the 1980s and the 2008 financial crash, combined with global central banks’ responses, meant they reached levels that shone a spot-light on the rigidities inherent within an income-only approach. This lack of yield has led to a number of responses from those following an income investing approach, ranging from the benign to the dangerous. These include:
- Accepting a lower income withdrawal: An honest approach, but probably not the optimum one as strong post 2008-09 crisis capital gains could have supported higher withdrawals if capital had been realised to supplement income.
- Reaching for yield: This is the phenomenon where higher yielding asset classes are used in the portfolio to keep yields up despite the fact they increase the risk of the portfolio and so lead to a greater chance of capital being depleted.
- Substituting capital growth for yield: Another technique for enhancing yield is to boost income artificially by sacrificing capital growth. This could be achieved by, for example, sacrificing equity upside by selling call options on equities owned within the portfolio.
- Plundering capital for yield: Towards the ‘dark arts’ part of the spectrum for enhancing yield is the technique of dividend or coupon stripping, where a manager buys stocks that are about to pay a dividend. A dividend is duly paid and the price of the stock falls to reflect the fact that the investor has received the dividend. At which point the stock is sold in favour of the next stock that is about to pay a dividend. This is a form of robbing Peter to pay Paul – the investor receives a higher yield but is usually worse off overall as their capital value falls and they pay away a lot in trading costs.
The benefits of total return investing
Proponents of income investing argue it is safest and leads to better long-term outcomes. Those in support of total return investing don’t dispute the importance of income, but rather note that both income and capital growth should be considered when designing portfolios. It is only by being aware of the sum of the two, rather than focusing on either individually, that proper long-term investment decisions can be made.
Most academics and well-respected mutual-fund families, including Vanguard and Fidelity, support total return investing over income investing for the following reasons:
- Greater diversification and opportunity set
- Greater tax efficiency (capital gains are often taxed at a lower rate than income)
- Control over withdrawal timing and amount
PortfolioMetrix too believes a total return approach is a better framework for investing than an income investing approach. We believe better diversification and tax efficiency are the key to investors being able to sustain higher withdrawals, with less chance of capital depletion.
This article was first published in The Trade Press publication in May 2017.