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Natural yield vs. total return
Comments
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Linton, doesn't backtesting show that over the long term (usually the medium term) Inc. units tend to appreciate in line with inflation, making sales from your growth portfolio unnecessary?
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If you restrict yourself to shares that pay high dividends, you have less diversification than if you tracked the market. In theory a less diversified portfolio has a lower expect risk adjusted return. Total return is the superior strategy, unless you can predict the future (or guess correctly).
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I want to draw a particular amount of cash each month automatically. Having to think about what to invest in be sure I have sufficient income is not for me. So I set up a gilt ladder to deliver the cash. Every now and then I lengthen the ladder by selling equities. So I am in the total return camp.
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While I don't quite fit the bill of relying on portfolio withdrawals (they currently form about 15-20% of our overall income), I do use a total return approach such that withdrawals are made every 6 months based on a pre-determined percentage of the portfolio (a variant of the bogleheads variable percentage withdrawals, or VPW, strategy). It is only a matter of calculating the overall value of the portfolio, the withdrawal, and then selling whichever parts of the portfolio are required to rebalance towards the target allocation and takes about an hour or so to sort out (if I continue to simplify my portfolio the time taken will reduce).
Most of the last 20 years has been relatively benign with annualised inflation of about 2.8% (although that means a 20 year increase in prices of 74%, e.g., see ) and, notwithstanding the GFC and covid, a total return in the MSCI world index in GBP of 546% (i.e., around 9.8% or 7.0% real, see ), so almost any strategy would have reasonably done well. It would be interesting to compare the performance of a natural yield strategy with total return in a more challenging period (e.g., 1970s) but the available data are limited (e.g., I have been unable to find long-term historical prices and dividends for income oriented investment trusts). The only backtest of a natural yield strategy I have seen can be found at (note that, FWIW, I disagree with his use of the term 'bonkers' - IMV, coupled with strong income floor from SP, DB pension, ILG ladder, and RPI annuity it is a perfectly sensible approach). The key take away from that article is that, historically, natural income varied a lot in real terms from one year to the next.
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One cannot identify a superior strategy without defining what one is trying to achieve.
Restricting oneself to shares that pay high dividends is not what is being advocated, rather to use appropriate investments for one's objectives. Relying on capital gain from selling volatile equity investments to provide a reasonably steady income would not seem to be an optimal use of such investments no matter what the long term overall return may be.
Currently my investment portfolio is split about 50:50 between income and growth. Income is automatically taken from the 50% equity/50% fixed interest income portfolio. The 100% equity growth portfolio is used to top up the income portfolio if necessary and very occasionally to rebalance with the major expenses cash pot. Though the cash pot is normally fed from excess income.
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Surely a gilt ladder is not a total return approach. It is closer to the type of strategy I advocate where the investments generating income are optimised for the purpose and are held separately from those for equity growth. My attitude to gilt ladders is that they sort of do the job but are rather inefficient. One can get much significantly higher income in other ways without the need for very regular replenishment, possibly at a time when you would rather not want to sell your equities.
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Another approach that seems attractive to many people (though not to me) is to use one of the increasing number of ITs guaranteeing a level of dividends, typically around 4% but some much higher, by paying any shortfall from capital.
The argument of boards being that it allows them to pay the high dividends that UK investors find attractive, while the manager can maintain a neutral stance in seeking the best total return. The popularity has had JPM convert several former growth ITs to growth and income on that basis. One result has been that having had an EM growth IT and an EM income IT, they now have two ITs both aimed at income seekers and no pure growth EM IT
I was interested to be recently told by the chairman of a large IT, that, despite the demand for high dividends, their research had found that over 60% of divis they pay are immediately reinvested back into their company - presumably after costs for dealing, SDRT, a spread, and possibly tax are paid. I accept that figure may differ between trusts.
But paying a guaranteed percentage of NAV is not the same as a fixed dividend, which could lead to disappointment when NAVs fall. One reason given for the fierce opposition both in principle and practice by some IT boards.
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Let's take a simple example and say I want to draw £1,000 per month. The gilt ladder delivers roughly £3,000 per quarter. A small bit of that is the coupon on all the gilts in the whole ladder, a tiny bit is the interest on spare cash but the majority is redemption of the last gilts. The actual income I receive on the gilts is irrelevant in my calcs. If my gilts have a high coupon, or a low coupon, I still get my £1,000. So it is the complete opposite of a natural yield strategy. The gilts I choose (whether high or low coupon) are chosen to maximise total return, not income.
I have no idea how to measure whether a gilt ladder is efficient or inefficient. It is designed to delivery certainty to me that I will get the cash each month. So it is an insurance policy designed to provide me with the level of income that I can happily on.
An annuity may make better sense as an insurance policy for some but it doesn't suit me at the moment. When I am older, perhaps.
Other than some spare cash for whatever, the rest is in a low cost well diversified tracker ETF. When I want to top up my gilts I'll sell some shares and buy some gilts. I've done that a few times when the market is doing well in an ad hoc way, lengthening the ladder as I go. If the market isn't doing well, I won't extend my ladder.
You are right that I might get to be in a situation where the equities are doing less well and I need cash. But I have a long enough ladder that means I don't need to get concerned about that for quite a long time.
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When a dividend is paid, the capital value of the share drops by the value of the dividend on the ex-dividend date. When you receive a dividend it comes from your capital. Dividend investing is total return investing where someone else decides how much money you withdraw.
Irrespective of how you draw income from shares, you will have a potential problem if company profits fall and the capital values of your shares drop. It is generally recommended that you hold a percentage of bonds to soften the blow when that happens.
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The problem with gilt ladders is that they are time limited. At the end of the period they are worth nothing. So if you are relying on them for anything other than income over a set period they must be inefficient - either you have to be very cautious by setting the end date long after you can reasonably expect to live (and hence reducing the annual income amount) or else you run a serious risk of ending up with zero income from it.
FWIW, I'm a fan of the natural yield approach and that's what we are doing in retirement. If nothing else it takes a lot of the psychology out of it. It's all very well to say that you can achieve the same result by selling shares / units but unless you have found yourself needing to do that just after they have fallen significantly in value then you don't actually know if you will do it.
The bulk of our income comes from a basket of investment trusts that all have strong records of dividend growth or at least maintenance. Some are low yield but typically above inflation dividend growth, others high yield with little expected growth. The basket produces an overall yield of just under 4% at present. Over the past year or so some of the ITs have been top-sliced with above-inflation growth put into gilts.
We've also got a much more adventurous portfolio of individual shares from which we're not taking any income but at some point profits will be used to purchase more of the IT basket.
Looking at all our liquid assets, percentages are:
Cash - 12%
Gilts - 10%
IT income basket - 56%
Adventurous portfolio - 22%3
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