Taking a total-return approach when rates are low

18 June 2019 | Markets and economy

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This low-interest, lower-return environment may tempt some income-focussed investors to abandon carefully-diversified portfolios in the pursuit of higher income.

However, this often involves investing in a higher-risk and lower-quality portfolio – without the benefits of proper diversification. Watch out for the traps of becoming an income-chaser.

Think about taking a total-return approach to investing for your overall investment portfolio as an alternative to being an income-chaser. Total-return investing focuses on both the income and capital growth generated by diversified portfolio.

This approach should help maintain a portfolio's diversification, allow more control over the size and timing of eventual drawdowns in retirement, and increase a portfolio's longevity.

Higher risk

Income-chasing investors often reduce their exposure to high-quality bonds and broad share portfolios to increase their allocation to higher-yield, higher-risk bonds and more concentrated portfolios of high-yield shares. Higher-yield shares are often concentrated in financials and utilities.

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

Investors who shift some of their fixed-income portfolio into higher-yield shares carry the risks of higher volatility and greater potential for capital loss.

Bonds as a diversifier

A critical role of quality bonds is to act as portfolio diversifier and a buffer to sharemarket volatility– not solely to produce income. Movements in bond and share prices typically have a low correlation. Don't overlook the diversification role of bonds when interest rates are so low.

Minimise investment costs

In a low-interest, lower-return environment, investors have even more reason to minimise their investment costs. By lowering investment management costs, more of an investment's return is left for the investor.

And the higher investment management fees across different asset classes, the higher the probability of underperformance*. Investors are increasingly using index-tracking exchange traded funds (ETFs) or index managed funds to gain low-cost diversity across at least the core of their portfolios.

Retiree trap

Many retirees try to base their retirement spending solely on the income produced by their portfolios. This can lead to retirees becoming income-chasers or too frugal given the state of their finances.

A classic Vanguard research paper, Total-return investing: An enduring solution for low yields, suggests that retirees consider taking both the income and the capital returns of a portfolio into account when setting retirement drawdowns and spending.

*The case for low-cost index-fund investing, Vanguard, 2018.

 

Written by Robin Bowerman, Head of Corporate Affairs at Vanguard.
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Robin Bowerman, Head of Corporate Affairs at Vanguard Australia, shares investment and personal finance insights gained from over two decades in the finance industry as writer, commentator and editor.

Robin Bowerman