In the current low-yield environment, income-oriented investors may be tempted to search for higher-yielding assets to support their spending requirements. However, according to a recently updated paper by Vanguard Investment Strategy Group (ISG), Total Return Investing: A Smart Response to Shrinking Yields, many investors seeking income would be better served if they adopted a total return strategy that spends through capital returns in addition to portfolio income yield.
“The total-return approach allows investors to meet spending needs without relying solely on portfolio yield,” said Vanguard ISG’s Jacob Bupp, who along with David Pakula, Ankul Daga, and Andrew S. Clarke has published new work based on Vanguard research originally produced by Colleen M. Jaconetti, Francis M. Kinniry Jr., and Christopher B. Philips. “It addresses portfolio construction in a holistic way, with asset allocation determined by the investor’s risk-return profile.”
After the COVID-19 pandemic jolted financial markets in March 2020, the already low yields on fixed income investments moved lower. At its 2020 low, the 10-year Treasury note yielded 0.52%, a fraction of its historical levels.
“The low-yield environment poses a challenge to income-focused investors who hope to use portfolio income to support spending,” Mr. Bupp said. “Today, a broadly diversified portfolio of equity and fixed income can no longer generate a yield equal to 4% of the portfolio’s value, consistent with conventional guidelines for spending from a portfolio” (Figure 1).
Figure 1. Yields on traditional asset classes fall below 4% spending target
Advantages and challenges of traditional income strategies
An income-focused approach has traditionally been favored by investors looking to maintain portfolio longevity. Spending is directly dependent on the portfolio’s yield, so a complex spending strategy is not required.
To meet traditional spending requirements in the current low-yield environment, many income investors will need to adjust their asset allocations. But as the paper points out, these income-seeking strategies come with considerable risk, including greater concentration in dividend-focused equities and greater exposure to higher-yielding fixed income investments that behave more like equities. Strategies such as these, which reach for yield, often lead to heightened volatility. (Figure 2)
Figure 2. A look at higher-yielding asset classes
“Tilting a portfolio toward higher-yielding assets and away from traditional asset classes only magnifies losses during times of market stress, including the recent market swings of early 2020,” Mr. Bupp said (Figure 3).
Figure 3. High-yield assets carried additional downside risk early in the pandemic
Total-return investing: A better approach
Mr. Bupp’s research also explores the benefits of a diversified total-return approach.
In contrast to traditional income strategies, the total-return approach generates income from capital gains in addition to portfolio yield. This approach begins with building a diversified portfolio matched to an investor’s risk tolerance (Figure 4).
When combined with a prudent spending rule, a total-return investing strategy has several advantages compared with the income approach:
- Portfolio diversification. Total-return strategies are much more diversfied across asset classes. Diversified portfolios tend to be less volatile and hold up better during stock market shocks.
- Tax efficiency. Investors with a total-return approach may pay less in taxes because part of their payment comes from capital gains, which are taxed at a lower rate than income.³
- More control over the size and timing of portfolio withdrawals. With a total-return strategy, investors may have more peace of mind because they can spend from capital gains in addition to portfolio yield. Numerous studies suggest that if you follow a disciplined withdrawal plan under a total-return strategy, your savings could last years.
Figure 4. Total-return approach versus income approach
“A total-return approach can help to minimize portfolio risks and maintain portfolio longevity, while allowing an investor to meet spending goals with a combination of portfolio income and capital,” Mr. Bupp said. “We strongly recommend this approach, particularly during this period of prolonged low yields.”
¹Yields are from January 1, 1990, to August 1, 2020. Asset classes and their representative indexes are: for global bonds, Bloomberg Barclays Global Aggregate Index USD Hedged; for U.S. bonds, Bloomberg Barclays US Aggregate Index; for global equities, MSCI World Index USD; and for U.S. equities, MSCI USA Index. The balanced portfolio is made up of a combination of the indexes for U.S. bonds (35%), global bonds (15%), U.S. equities (30%), and global equities (20%).
²Returns are from February 3, 2020, through March 31, 2020. Asset classes and their representative indexes are: for Global REITs, MSCI ACWI Diversified REIT Index; for emerging-market bonds, Bloomberg Barclays EM Aggregate Index; for global high-dividend equities, MSCI World High Dividend Yield Index; for global high-yield bonds, Bloomberg Barclays Global High Yield Index; for long-duration fixed income, Bloomberg Barclays Long U.S. Corporate Index; for globally diversified equity, MSCI AC World Index; for globally diversified fixed income, Bloomberg Barclays Global Aggregate Index Hedged; and for balanced portfolio, 50% equity/50% bond allocation from MSCI AC World Index and Bloomberg Barclays Global Aggregate Index Hedged, respectively. All indexes are in USD.
³Qualified dividends are taxed at the capital gains tax rate, a lower rate than the federal marginal income tax rate.
All investing is subject to risk, including the possible loss of the money you invest. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss.
Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
“Total-return investing: A superior approach for income investors”,