For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Why is there such an disconnect between total return proponents and income investors?
It is self-evident that total return is the most critical measure of a portfolio, whether in accumulation or decumulation. This combined with the volatility of those returns will determine the success of an investment strategy over the long term, both pre – and post-retirement. Hence, the proponents of a unit encashment approach post-retirement focus on total return and ignore the income level or even the income potential of a portfolio.
Natural income proponents however, focus on the income level and do not try to forecast the total return. Drawing only the income, assuming this is predictable and growing over time, provides a degree of stability and never requires dipping into capital to fund expenditure.
Of course, most portfolios are insufficient to fund retirement spending from income alone. Even for those that would prefer a better lifestyle rather than leaving the entire capital to their heirs. Therefore, even natural income proponents recognise that a degree of unit encashment will be necessary.
Most income proponents will, in practice, be comfortable with a pragmatic blended approach. Yet many of the total return focused investors are determined to dismiss income in an almost religious fashion.
The arguments against using income center around a number of areas, many of which we believe are quite valid.
Firstly, are the dual problems of the unpredictability of income and the unreliability of an income style in total return terms, both of which are valid for a lot of funds. Many funds calling themselves ‘income funds’ are no longer focused on providing a stable and growing income for their investors. This may have been the case many years ago, when income funds were widely used for this purpose. Following the rise in total return-based performance tables, combined with the superior returns of growth strategies over the decades of ‘lower for longer’, meant that to survive these funds typically dropped their focus on income as an output. While many remained focused on income as an investment style (a subset of a value style), few focused on their actual distributions. In some ways this was a doubly unhelpful approach as these funds would now provide an unreliable income stream and would only perform well when value as an approach was in favour. For an adviser trying to achieve their client’s income objective this is doubly unhelpful. Hence, we completely understand this criticism when applied to most funds calling themselves income funds.
What it misses is two important factors. One is that there does remain a precious few funds that do still manage their distributions. This is entirely possible, particularly in the context of a mixed asset, or at least global portfolio. If a fund is tied to a single asset class or region then little can be done if an income shock hits, such as occurred to UK equities in 2020. Having the flexibility to diversify correctly, different sources of income enables a manager to avoid such difficulties if he is focused on providing that income stream.
Secondly, it is not necessary to follow an income style or value style of management to provide a high- and growing-income stream. See the recent notes Third way income and Meta is an income stock, which discusses using growth stocks to provide income. Run pragmatically, an income fund can perform across all market environments.
Another related critique is that income funds are often poorly diversified, which again we fully agree with. Many income managers came from a UK equity focused background, having found the reliability of UK dividends attractive. Hence, they have tended to be overly exposed to UK equities, which in recent years has been a very poor strategy. This has meant that these managers have missed both the excellent total returns available from growth stocks (particularly those in the US) in recent years as well as some excellent income and total returns which have come from a wide variety of international equities.
Similarly, a focus on semi-passive UK fixed income approaches means many funds ignore the wide range of income and total return opportunities from global fixed income markets. Additionally, many income focused funds do not even consider non-income producing asset classes such as gold and commodities. By narrowing the investment universe, many income funds are by their nature less well diversified than some less constrained mandates. This is not just the case with income strategies, many non-income mixed asset strategies narrow their universe deliberately by focusing on a growth style or an ESG mandate. We think an entirely pragmatic approach is better, whether the desired outcome is income or total return.
To this point the additional downside risk of many income strategies comes from their focus on higher income levels rather than total return with income as the output. Obviously, high yield bonds are riskier than investment grade, deep value high yielding equity is riskier than quality growth or defensives. We would never suggest such an approach is appropriate in a low-risk mixed asset fund.
The chart overleaf shows the MSCI World High Dividend Yield Index versus the MSCI World Index. An income style of management has underperformed but not all income funds have done badly.
MSCI World High Dividend Yield Index versus the MSCI World Index
Source: Bloomberg 16.05.2014 to 07.05.2024. Past performance is not a reliable indicator of future returns.
In summary, most of these critiques are valid when applied to most of the available income strategies, mainly because of the failure of these strategies to focus on the client need – a steady and growing income. Instead, they have a focus on beating a peer group or index, maximising income for income’s sake or pursuing income as a value investment style.
What all this misses however is the real value of income to an adviser: well managed income can provide a level of stability to a client portfolio that volatile total returns cannot. In drawdowns, if the income on the portfolio is unimpacted or suffers limited impact, a client can observe that the real value of their portfolio might be less at risk than they might otherwise think. As a result, they might be less inclined to panic and withdraw. The major benefit to advisers is that at the point of investment the fair expectation of total returns is the income plus expected future growth and therefore provides a strong anchor on expected returns rather than an ambiguous long term return forecast. On what are future return expectations to be based if not the future cash flows from a portfolio? Long term returns are particularly difficult to assess in an environment of highly fluctuating market levels, leading to uncertainty as to the prudent withdrawal rate. Knowing the natural income level of the portfolio fixes a rate that can be withdrawn before capital is eroded. The market is therefore telling you the safe withdrawal rate, as markets rise the rate may fall but the income remains the same and vice versa, year by year, day by day. With a growth strategy you are having to guess this rate.
