Rudi Minbatiwala explores the challenges of balancing long-term capital preservation with immediate income needs.
The definition of a return objective for many outcomes-based investment strategies places greater emphasis on the income requirements compared to traditional wealth accumulation strategies. Generating a sustainable level of income in retirement becomes a key priority.
This is often sought by a shift towards maximisation of income rather than maximising return for a given level of risk.
This creates a challenge when considering the appropriate strategy for the Australian equities component of an outcomes-based investment solution, given the asset class is typically regarded as a growth allocation.
The status quo response has been to target an equities mix that tilts towards higher-yielding investments to match the overall return objective for these investment solutions.
When planning for post-retirement, investors forecast their future annual spending requirements in dollar terms.
After accounting for any supplementary income they may receive, such as age pension entitlements, the residual amount is the income their portfolio must generate to fund their retirement.
This requirement is simplistically expressed on a yield basis as the current year investment income requirement as a percentage of the client’s accumulated wealth. Due to the immediacy of the income need, achieving this income requirement becomes the priority investment objective.
The challenge when designing an appropriate investment strategy for these outcomes-based investors is to ensure we retain a focus on the long-term growth and capital preservation objectives while addressing near-term income objectives.
Australian equities
For Australian equities, the most common investment approach used to address the achievement of the portfolio yield target is to simply tilt a portfolio towards stocks that pay high grossed-up dividend yields.
This simple approach is often adopted because the terms yield and income are habitually used interchangeably when describing investment strategies.
It is well known that dividends from Australian shares have been a resilient source of income, with the income received growing at a rate that exceeds inflation over the long term.
Therefore, it is a rational expectation that investors are attracted to the apparent stable growth income characteristics of Australian shares.
While Australian shares have historically provided a good source of income, investors often extrapolate from this that they can increase the amount of income generated each year by limiting their investments to stocks that pay high dividend yields. Does this simple approach deliver the desired outcome?
Seeking higher income from equities by tilting to stocks with higher yields results in skewed portfolio positioning and unintended bias towards certain areas of the market.
How will the resultant share price performance difference impact on income generation?
There is a need to understand the role that capital growth over time plays in generating an attractive income stream from Australian shares over the long term.
Growth returns
It may sound counter-intuitive, but equity investors aiming to maximise their income return over the long term must continue to retain a focus on the growth returns of the equity market. This is best explained by the example in Figure 1, which highlights the ‘cost’ of targeting higher yielding stocks.
If an investor seeking a higher level of income from their equity investments 10 years ago was presented with a choice between an investment in Telstra and CSL to generate ongoing income, most rational investors would have chosen Telstra due to its higher dividend yield.
Figures 1 and 2 show investors who chose Telstra would have been worse off from an income received perspective, even after accounting for the benefit from franking credits.
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The key thing that stands out is that while the consistency of the dividend component is evident (stable yellow bars), the dividend cash stream cannot be accessed without owning the shares, thereby exposing investors to the impact of movements in PERs and EPS revisions.
These two sources of return are the dominant factors on share price performance and both are highly volatile.
This outcome is not isolated to constituents of the S&P/ASX 100 Index. Any number of well-known high yield stocks show very similar results.
The fact that the volatility of dividends is significantly lower than the volatility of share prices should not be extrapolated to justify a simple investment strategy targeting high dividend yield stocks. This applies even for outcomes-based investors who are concerned about the return path of their investments.
Rudi Minbatiwala is a senior portfolio manager, Australian Equities, Core at Colonial First State Global Asset Management.
