Natural yield vs. total return

aroominyork

Heading into retirement I tweaked my portfolio late last year so most of our income needs come from yield on savings, bond funds and equity funds. I recently watched a YouTube video by James Shack (aka the man in the kitchen) who said it makes no difference whether you go for natural yield or total return because, when an Income fund makes a distribution, the fund price falls by the amount of the distribution. The bottom line is no different than if you sell units from an Accumulation fund.

I couldn’t see many flaws in his argument if your Acc. sale is equivalent to the Income fund’s distribution. Is the other difference that equity income funds – as opposed to growth funds or vanilla index – can be less volatile so you have a smoother flow of returns? My guess I am missing something – what is it….?

El_Torro

I guess Jimmy's right, though it depends what we extrapolate from there.

For example if you go for a fund that focuses on giving you a high level of dividends then arguably you are losing out on stocks that give a great overall return but a low yield.

If all we're doing is comparing an Acc fund with the same Inc fund then yes, I think that line of thought is correct.

masonic

There are a couple of minor things:

• The type of company that pays a decent dividend tends to be in a sector that is less volatile, so it will bias the fund away from sectors like tech and countries like the US (where tax policy drives companies to buybacks rather than distributions)
• Dividends can be cut during recessions, so cannot be relied upon, but they can serve as a limiting factor for those drawing an income, delineating what is sustainable vs unsustainable

I suppose there is also the psychological aspect of the investor not having the perception of taking money out themselves in a downturn (and they can usually automate the process of withdrawing to their bank account)

aroominyork

I agree with all of that, El_Torro & masonic. I have no interest drawing minimal income from vanilla index funds so my only equity income funds are UK (Vanguard's equity income) and DEM in emerging markets. Bonds are a better place to find income - that's much of their raison d'être - though you still have the option of taking yield or selling units.

dunstonh

I recently watched a YouTube video by James Shack (aka the man in the kitchen) who said it makes no difference whether you go for natural yield or total return because, when an Income fund makes a distribution, the fund price falls by the amount of the distribution. The bottom line is no different than if you sell units from an Accumulation fund.

It is a technically correct answer. But there are differences in the companies that heavily favour yield or growth, and they tend to cycle.

Total return and yield are influenced by companies that behave differently at various times. You tend to find higher yields in more mature businesses where there is less need to reinvest every pound of profit back into the company, allowing more to be distributed as dividends. Such companies often trade on lower valuation multiples and are considered part of the “value” sector. Conversely, traditional growth companies usually pay lower dividends because they reinvest more of their internal cash flow to fund future expansion – think of many tech firms. Over the past decade or so, especially with the dominance of US mega‑cap tech, those growth areas have been the focus, which explains why total returns appeared so strong and why market‑cap‑weighted global trackers (heavily skewed towards the US) have performed so well. The opposite is true: if leadership shifts back towards more value‑oriented or non‑US markets, a heavy US exposure could be detrimental, just as it was after the dot‑com crash when the cycle was more focused on value.

If you look back in time, it hasn't always been that way. After the original dot-com crash in the early 2000s, cheaper, often higher-yielding “value” shares dominated for a period, and long-standing posters will recall the HYP discussions from that time. Around the time of the credit crunch, value was severely impacted – not least because financials and some other major dividend payers were at the heart of the crisis, with names like M&S and BP facing well-publicised issues. Over the longer term that followed, ultra-low interest rates and the rise of mega-cap growth stocks meant that growth styles generally led the market, although there were occasional spells when value performed well.

More recently, signs of another style rotation have emerged, with phases where higher‑dividend/value sectors and then growth/tech have alternated in prominence. Whether this will develop into a lasting cycle change or just remain a short-term blip is uncertain – my crystal ball is no better than anyone else’s.

Linton

If you want income to cover expenditure relying on total return by selling units and taking natural yield of dividends and interest are very different:

1. Taking interest and dividends can be completely automated if you use S&S ISAs. No requirement to take action each time you want a payemnt.
2. No continual decision making on what and how much to sell and no need to continually follow share prices.
3. Yield in £ terms is much more stable than capital value. Capital values rise and fall with market sentiment in reaction to short term external events. Yield in £ terms depends on the health of the underlying companies which varies over a much longer time frame and is not highly correlated. The underlying companies have a strong incentive to maintain the dividend.
4. No need to set up strategies such as cutting expenditure (Guyton Klinger, guide rails etc) to deal with major crashes

The effect of these benefits is that taking an income is pretty much stress free.

As to equity vs Fixed Interest: As is usually the case with investment either/or questions, both with high diversification is the right answer. Although the US is difficult for equity income, europe, especially the UK, is fine and SE Asia very good. One can get US coverage from investments like infrastructure and corporate bonds.

That is my experience from running an income portfolio for the past 20 years. It would be interesting to hear from a retiree who needs significant ongoing income from their investments and has long term experience of living with a total return strategy.

leosayer

Being retired and living off the interest or dividends is an attractive goal and has always been simple to implement - in the past this was much simpler and cheaper than phoning a broker and paying high transaction fees. You just let the dividends roll in.

But with today's almost zero-cost platforms, it's hardly any more difficult to sell what you need when you need it and not be subject to the variable amounts and timings that dividends give.

Unless you're lucky enough to have so much invested that you can comfortably live off the dividends (for example, global equities yield around 1.3%) then selling assets to pay for your retirement spending is a sensible way to ensure that you don't die with a larger than necessary remaining balance.

LHW99

One other factor s that if you sell regularly during a downturn, you are reducing the number of shares you own and possibly limiting the amount of rebound once markets move up again. This can become important if the downturn is not quick to recover IMO

Taking natural yield means that as long as you can live with a degree of variability, the capital value of the holdings becomes rather less important.

masonic

https://forums.moneysavingexpert.com/discussion/comment/81913552#Comment_81913552

I'm trying to recall the video, and IIRC, this was exactly the argument James was countering. In a like for like comparison (dividend reinvested, then sold vs paid out), it makes very little difference financially. You would own fewer shares in an Acc fund, but they would be worth more due to reinvested dividends (or reinvested profits, or share buybacks). An issue could arise where you are drawing down substantially more than is sustainable for the fund, but in that scenario you'd be selling income units too. So it becomes a case of not drawing down too much in either approach, rather than natural yield vs total return.

The main problem I see with a total return strategy is in the execution. Many investors simply won't have the confidence or discipline to make the right calls when things get tough. It will also tend to require them to monitor their portfolio closely and bring them into proximity to the 'Sell All' button rather too frequently.

Bostonerimus1

When a company gives a dividend it's distributing profits to share holders and there is a consequent drop in the company coffers which is reflected in the valuation. However, if you are going to emphasize companies with a history of regular dividends over total return you will be driven away from volatility and into sectors like utilities and large cap companies…so it devolves to asset allocation.

Cash and bonds are a little different as they are "fixed income" as you know how much you are going to get when they are held to term. There's a place for interest, dividends and capital gains in most retirement portfolios. I don't see the problem with using natural yield for basic income and then selling growth equities to make up the rest. You can follow a few rules/algorithms that are relatively simple if you have a neat and tidy portfolio of a few funds rather than double digits of funds.

Linton

https://forums.moneysavingexpert.com/discussion/comment/81913470#Comment_81913470

Living off equities is straightforward. There are plenty of income funds.

UK income equities are around 4.5%. Far east equities can be rather more. Then add in Fixed interest at 7% or more. That leaves 6% readily available without taking extreme risks..

I split my investments into 2 separate portfolios. About half is in income funds the other half in 100% equity. Over the long term the equity portfolio will purchase further income fiinds to increase the income in line with inflation. Working in this way ensures one is not trying to take income from volatile equity.