When it comes to clients wanting an income from their investments, constructing portfolios that will generate a particular natural yield tends to be the default choice for many advisers. But natural yield investing can be a challenging strategy, and one that isn’t likely to deliver the best investment outcomes over the long-term.
A better option is to adopt a total return strategy which involves investing for both income and capital growth and entails selling some units from the portfolio over time. This option is not always popular amongst investors who rely on their portfolios for income due to a widespread fear that if they do periodically sell shares in their portfolio or units of mutual funds they hold they’ll eventually ‘run out’ of shares/units and thus money.
Instead, they feel more comfortable investing in high yielding instruments (no matter how risky or negatively it impacts portfolio capital growth), never selling anything and living off any dividends, coupons and interest generated by the portfolio.
This fear of selling units is misplaced and results from the confusion of capital – how much an investor has invested – with the number of securities or units of funds that an investor holds. It turns out that whilst protecting capital (the number of units/shares multiplied by their price) is very important, this is actually very different to never selling units. Investors can quite easily go on selling units and never run out because neither the price of those units, nor even the stock of units they hold, is actually ‘fixed’ over time.
Units of a mutual fund can be traded fractionally, which means it’s possible to keep selling successively smaller portions of units without running out. And whilst shares can’t be traded fractionally and need to be traded in whole numbers, the number held can increase without buying or selling due to share splits. A share split is simply where a share previously worth €100 becomes two shares worth €50 or four shares worth €25 due to a corporate action. For example, Apple saw its shares split multiple times over its listed history: 2 for 1 in each of 1987, 2000 and 2005 and 7 for 1 in 2014 (a 56-fold increase overall).
So, whilst it seems counterintuitive, it is possible to keep selling units (or fractions of units) and never run out. However, for investors living off their portfolios to do so successfully does rely on the value of the units/shares growing in price to support future withdrawals from the portfolio. Apple is a remarkably extreme example, but the reason a single share at IPO in December 1980 (worth $22 then) could become 56 shares today is that the capital return on that one original share has been well over 400 times what would have been paid at IPO.
Of course, dividends, bond coupons and interest are all extremely important sources for long term returns and it’s important to strike the right balance within a portfolio. But investors and advisers should not ignore the importance of capital growth when designing long term investment portfolios.
Instead advisers should work with clients to understand any biases they may have around selling units and strive to limit the perverse effects of these biases as much as possible. That way they will be best placed to deliver the combination of income and capital growth likely to maximise the risk adjusted total return of client portfolios and meet clients’ long-term income goals.
To find out more about why focusing solely on natural yield is not the best way to build portfolios and meet long-term client outcomes, you can download a free paper called ‘Yield of Dreams: can you live off natural yield?’ from the PortfolioMetrix website. The paper delves deeper into the rationale outlined in this article and explains why total return investing is a more robust alternative for advisers seeking to meet income targets for clients.
This article previously appeared in The Trade Press publication – FEIFA July 2018
Download whitepaper: Yield of Dreams: can you live off natural yield?
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