September 21, 2023

Investing in a World of Improving Income Returns by James Smith

Investing in a World of Improving Income Returns is the third article in James Smith’s 2023 Investment Series.

Depending on an investor’s risk profile and stage of life, income can form a crucial part of the construction and asset allocation of an investment portfolio. When an investor retires (or has a liquidity event such as the sale of a family business), they are likely to move away from a salary or profit-derived income and possibly become more reliant on investment-generated income. In this instance, the composition of their investment portfolio becomes more profound.

With a change in circumstances, many investors choose to construct their portfolio with greater diversification and in many instances, a more conservative risk profile (less growth assets and more defensive, or income producing assets). This can often be the complete opposite to what has got them to the position they are now in (such as having a heavy concentration of asset exposure to say a family business which created the liquidity event for example).

In the past, a more defensive portfolio would favour income over growth with a traditional ‘conservative’ portfolio holding around 60% of assets in defensive asset classes (cash, fixed income, credit) and 40% in growth assets (equities & property). Indeed, in more recent years, it could even be said that the mix between growth asset classes and defensive asset classes in a conservatively structured portfolio has experienced somewhat of a ‘style drift’ favouring a greater tilt to growth assets at a Strategic Asset Allocation level.

Over the last 8 years as the RBA cash rate fell from 2.25% in 2015 to 0.10% in 2020, such a conservatively constructed portfolio has provided subdued income as a percentage of the overall return. We highlighted this in an article in 2019 addressing the possible requirement of a conservatively minded investor needing to consider increasing the proportion of growth assets in their portfolio to capture income, with the collective risk attached in doing so, as the defensive part of their portfolio was impacted by subdued income via low interest rates.  Click here to read the 2019 article.

With such an aggressive rate tightening cycle being enacted by central banks (the RBA by way of example has increased rates in Australia 12 out of the last 16 meetings lifting the RBA cash rate to 4.10%), investors can now once again harvest yield from the more defensive asset classes within a portfolio. Not everyone is comfortable taking elevated risks to generate a return.

Such a conservative portfolio has historically provided returns of around ~5.8% pa*.

Whilst we believe longer term returns are likely to be lower than experienced over the last few decades, once again, following such an aggressive rate tightening cycle by the RBA, a conservatively constructed investment portfolio is now expected to generate a return of ~5.15%, of which @4.15% is income**.

For investors seeking capital preservation and peace of mind, the historical draw down of a conservatively constructed portfolio in market corrections has been less severe than a portfolio with a greater bias to growth assets. A healthy balance for those seeking income and security, as it provides modest capital growth while maintaining greater focus on capital preservation.

As mentioned above, after a prolonged period of ‘income drought’, the composition of portfolio returns has now changed. Over the last few years (following an aggressive rate tightening environment) a conservative portfolio has seen its income component progressively enhanced. This has mostly been driven by an improvement in fixed income returns, largely priced off the movement of government bonds. A welcome reversal for a more risk averse investor who is reliant on the income returns from their investment portfolio with a greater weighting to such assets.

This has essentially reversed a profound quandary for the investor as highlighted in our original article in 2019.

Defensive portfolios are once again able to harvest yield.

With this changing dynamic of more income generation from the ‘defensive’ assets in a portfolio, this may allow some investors to pare back their risk exposure in favour of a more conservative stance which might be more akin to their level of overall risk tolerance.

I suspect that in recent years following diminished income generation from traditionally defensive assets, some investors may have been forced into the possibly uncomfortable reality of increasing the ‘risk’ component of their portfolio to capture income (increasing their exposure to Australian equities for example to access dividends).

For the purposes of this article, we will reference the changed dynamics of income generation for a conservatively constructed portfolio from 2019 to present day.

Consider the following:

·       A conservatively constructed portfolio based on a Strategic Asset Allocation* assumption of 60% defensive assets and 40% growth assets is likely to have had a ~50% (138 basis points) increase in income from 2019 levels of 2.77% to now closer to ~4.15%.

·       Income generated from a conservatively constructed portfolio has now reverted back toward the more defensive components of the portfolio.

·       This allows the opportunity for a more risk adverse investor to pare back their ‘growth’ assets within their portfolio to something that may be more reflective of their risk tolerance.

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