Income investing is an investment style that can divide opinion as easily as Brexit politics over a family dinner. At IBOSS, we are no strangers to income related queries, having managed our income portfolio since November 2008 and currently being in the process of launching our own new income range. Considering this, we thought it would be worth looking at 3 ‘universal truths’ of income investing.
Universal Truth #1: The 4% Rule
The 4% rule is the income withdrawal figure currently perceived by many investors as a “safe” withdrawal rate for a portfolio. This has, subsequently, become a target that many multi-asset managers and advisers look to achieve through an income product. However, with bond yields trading at close to historic lows, there are a decreasing number of assets that trade around or above 4% or anywhere close to it.
UK equities are, and have been, a consistent exception as the average dividend yield remains high relative to history at 4.26%. Despite this, it may come as a surprise to some that many equity markets produce a far lower average yield. US equities, for example, have produced on average a yield of only 1.80% – substantially lower than the 4% target. According to 2019 data, the only equity markets to have produced a yield of close to 4%, other than UK equities, are Spanish equities (4.37%) and Australian equities (3.95%).
Within fixed income the situation is much the same; consistently low(er) interest rates have meant that higher yielding assets are becoming ever harder to find and the two drivers of increasing yield – extending duration or increasing credit risk – have limited scope to increase yields. Using the same format as above, the only IA Fixed Income sectors delivering an average income of over 4% are high yield bonds (4.40%) and emerging market bonds (4.58%).
In short, constructing a portfolio with a yield of over 4% is very difficult without investing in very specific areas of the market. As the famous DeVoe quote goes “more money has been lost reaching for yield than at the point of a gun”. Essentially, investors search for higher yields and lose money when safer, lower, total returns were available. It is especially difficult to reach a 4% yield whilst providing a fully diversified portfolio, considering the areas where yields are highest. To summarise, we feel this reach for yield necessarily leads to concentration risk.
Universal Truth #2: The Power of Income
A company’s share price is obviously an important factor to consider for investors however many liken income paying equities to the tortoise in Aesop’s fable; the theory being that the consistency of income payments is far more important for total returns than movements in share price.
We ran the figures ourselves using the IA sectors and the above does hold true for UK Equity Income stocks however, as with all things investing, it really does depend on the timeframe. An income bias in UK equities hasn’t worked for any period under 15 years but has outperformed over the very long term. It is worth noting, for data which includes the last 12 years, that has been the era dominated by central bank policy; this domination is unlikely to go away and in fact many see their interference in the mechanics of markets only increasing. In summary, with or without central bank interventionist policies, you have had to be very patient.
IA UK Equity Income against IA UK All Companies (Income reinvested)
At first glance, the situation seems less convincing when assessing the success of global equity against global equity income. Here the average global equity income fund has underperformed over all the cumulative time frames above. However, the situation isn’t quite as clear cut as the cumulative figures suggest; for global equities and UK equities it has been the last 5 years that have really impacted relative performance as share price, rather than income, has led total returns. A period that has, overall, been dominated by the outperformance of US growth stocks and the underperformance of value stocks in other geographies many of which are income producers (financials, energy etc).
Overall, the answer isn’t clear cut and whilst income is a key component of total return so too is growth, a point that has clearly been evidenced over recent years.
10 Years – IA UK Equity Income relative to IA UK All Companies (Income Reinvested)
Universal Truth #3: The Comfort Factor
Though this truth is less quantifiable than the previous two, it is equally as relevant as it reflects the behavioural biases of many income investors. Income portfolios and funds tend to have a larger allocation to blue-chip companies that both investors and clients have likely heard of. Many consider companies that pay a dividend to be “proper companies”, a point which is perhaps more intuitive than it initially sounds. Investors put their capital into businesses to achieve a share of the profits, a situation that only really occurs upon dividend payments, and companies which can consistently pay a dividend should have predictable cash flows. Additionally, these dividends can be paid irrespective of stock price movements, offering two methods of generating return – growth & income.
Our own thoughts on income investing are relatively simple. Namely, selecting assets that provide a yield can be of significant benefit to portfolios. These assets provide exposure to larger and, potentially, more stable companies that are, currently, cheap relative to growth stocks. However, issues arise when investors look at total yield as the be all and end all. Our belief is that income can be a priority for those with an income mindset however, both capital and diversification are still, in our opinion, key to long term performance. Our income portfolios will aim to provide what we consider to be a sensible income, whilst targeting a fully diversified portfolio.
Dividend Yields by Geography: http://siblisresearch.com/data/global-dividend-yields/
Historic highs: https://www.ft.com/content/f052c376-c4e1-11e9-a8e9-296ca66511c9
The power of Income (liontrust): https://www.liontrust.co.uk/benefits-of-investing/power-of-income