ETF provider Vanguard supports total return over income investing

Mar 2nd, 2016 | By | Category: ETF and Index News

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Vanguard, the world’s second largest provider of exchange-traded funds, has released a report showing that investors can achieve superior performance from a total return framework in portfolio allocation compared to an income approach.

The report, which addresses portfolio allocation decisions related to investors with specific liquidity needs, such as retirees, compares the characteristics of two strategies – an income-focused approach and a total return approach. Its findings show that the adoption of a total return framework provides superior diversification, withdrawal control, tax efficiency, and portfolio longevity compared to an income approach.

ETF provider Vanguard makes the case for total return investing

Vanguard argues that a total return approach to investing is superior to an income-focused approach in terms of diversification, control of withdrawals, tax efficiency, and portfolio longevity.

While both strategies share similar features it is the source of return that is different. An income approach focuses on supplying liquidity through the natural yield of portfolio securities (coupons and dividends), while maintaining the total real value of the portfolio through steady capital appreciation. A total return method derives the return to fund the investor’s liquidity needs from both the natural yield and capital appreciation of portfolio securities. As such, the total return method usually invests in riskier assets, and plans to periodically sell overvalued stocks to fund withdrawals.

Many investors tend to prefer the income approach due to its simplicity and its focus on assets with a lower risk of capital depreciation (a key consideration for retirement savings accounts).

Vanguard, who recently expanded its suite of fixed income ETFs, providing investors with more products to build comprehensive portfolio strategies, argues that investors’ preference for income-focused portfolios may be misplaced as total return strategies actually provide several benefits.

One of the issues with the low-yield environment is that many income-sensitive investors (including retirees) have looked for ways to maintain income while preserving the value of their capital.

Todd Schlanger, Investment Strategist at Vanguard, said in a note: “As a result, investors have pursued higher-yielding investments, such as non-traditional bonds (high yield, emerging market, or strategic bond funds), property investments (both public and private market), and equity-income strategies. This can increase the portfolio’s risk profile and may not be in the investor’s long-term best interest.”

Vanguard suggests these investors take a total-return approach to portfolio construction because of the advantages of diversification, control of withdrawals, tax efficiency and longevity.

Diversification is a key benefit of the total return approach. Compared to the income approach, which tends to focus on a narrow range of asset categories mainly restricted to developed market sovereign and high quality corporate bonds, this greater diversification means total return portfolios are able to reduce idiosyncratic risks (such as firm, sector or style risks).

Another benefit in total return is the flexibility over timing and size of withdrawals. This compares to the income approach which often sees investors limit their withdrawals and lifestyle spending if natural yields fall.

Total return approaches are also advantageous from a tax perspective compared to income approaches for UK investors. Current tax law in the UK levies a 37.5% tax against interest and dividends but only a 28.0% rate against capital gains. Furthermore, there is an annual tax free capital gains allowance of £11,100.

Owing to a more favourable tax treatment (which effectively enhances final returns) and the ability to better control the timing and size of cash flows, investors are able to increase the longevity of their portfolios using a total return approach. This means the portfolio can meet the investor’s spending needs for a greater period of time compared to an income-focused approach.

An income strategy may also deviate from its low-risk approach given the persistent low-yield environment. In the search for higher yield, managers often move part or all of an income-focused portfolio into higher-yielding fixed income instruments, property shares, or income-generating equities, all of which have their own unique set of risks.

Lastly, income-producing equities have historically exhibited far greater volatility of returns compared to broad market bond indices, serving to significantly change the risk profile of an income-focused portfolio which goes down this route. Furthermore, the belief that high dividend stocks will outperform regular equities may be fundamentally flawed from a capital budgeting perspective which views cash distributions as an allocation decision based on a lack of profitable alternatives.

A key consideration for investors regardless of the actual strategy chosen is to keep investment costs low. ETFs tend to offer lower fees than other investment vehicles offering similar exposures. Vanguard, known for its low-cost philosophy, offer the Vanguard S&P 500 UCITS ETF and Vanguard FTSE 100 UCITS ETF with fees of 0.07% and 0.09% respectively; a suite of fixed income ETFs at 0.12%; and the Vanguard FTSE All-World UCITS ETF at 0.25%.

 

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