Investors have long differed when it comes to various aspects of investing: how to best diversify a portfolio, which stocks and bonds to own (if any), which investment products and strategies make the most sense, and so on. But opinions become particularly polarized when trying to determine an optimal strategy for generating income. Is a Total Return approach that puts some emphasis on growth the right course, or is it better to use an Income-focused strategy designed almost exclusively to create cash flows?
Framing the Debate
Total Return absolutists will argue that a client can meet their income needs while also allowing for the possibility of growth over time, assuming the investor is willing to accept a certain level of risk. In this approach, the focus is on income alongside price appreciation. Loss of capital may be more readily accepted by a Total Return investor, since the strategy may call for a mix of riskier assets to yield the desired result. This creates a broader range of investment possibilities for the Total Return manager, such as the ability to invest in potentially riskier asset classes like equities, REITs, and commodities. The portfolio may produce some level of income from bonds and dividends, but since income is not the primary objective, securities may need to be sold in order to generate cash.
Income proponents will argue that a strategy focused on producing high, predictable, and reliable cash flows with potentially lower price volatility is a more appropriate approach for investors with specific cash needs. Here, the emphasis is more on capital stability rather than growth or price appreciation. This typically implies that the Income manager prefers using various types of bonds, and perhaps some dividend-producing securities (depending on a client’s risk tolerance), to produce steady annual cash flows. In order to maximize income, the investor will likely need to assume some level of risk, though by definition the strategy’s main objective should be to rely on dividends and interest payments as income sources—without eroding principal.
We think it makes sense to explore the pros and cons of each, and ultimately believe that there is in fact a superior strategy: the one that best matches the client’s goals.
The Total Return Approach:
- Potential for price appreciation and growth over time by owning riskier assets
- May provide income from a diverse range of asset classes, such as stocks, bonds, REITs, and commodities
- May allow for tax efficiency since the investor can choose which securities to sell (at gains or losses) in order to generate cash; long-term capital gains are typically taxed at lower rates than dividend and interest income
- Potentially higher risk of capital loss and heightened volatility throughout the holding period
- Downside volatility and headline risk may result in emotionally-driven requests by the client to sell certain securities at disadvantageous times – especially if short-term thinking is contrary to the strategy’s long-term approach
- In the event that the strategy does not produce enough income to meet the client’s needs, sales of securities would be necessary – which could prove challenging or time-consuming and lead to less than optimal investment outcomes
The Income Approach:
- Typically provides reliable, mostly predictable levels of income automatically through coupon payments, and in some cases, dividends
- With a primary focus on generating income, such a strategy may provide a higher yield (and potentially higher risk) than traditional fixed income instruments, such as bank CDs and U.S. Treasuries
- Typically aims to preserve capital and protect principal over time, with a lower standard deviation (less risk) than a Total Return strategy
- May produce lower long-term annualized growth rates than a Total Return strategy
- Dividend income is typically taxed at ordinary income rates (qualified dividends, however, are treated like long-term capital gains)
- With a primary focus on generating income, this strategy may be less diversified across asset classes
Strategy in Practice: How a Total Return and Income Approach May Differ
An example may help illustrate the differences between the two strategies. Recently, the price of oil declined over 50%, and the prices of many related bonds were adversely impacted as a result. In this type of scenario, a Total Return manager’s response would likely be quite different from an Income manager’s.
Total Return Strategy: Typically, the manager would analyze the credit of the impacted bond, but would also re-evaluate the holding based on its price. The manager would assess whether the bond’s price is expected to rebound and how quickly that might happen, and based on that opinion may sell the holding, keep it, or buy more. The manager might also hedge the holding with a natural hedge or an arbitrage opportunity.
Income Strategy: Typically, the manager would first analyze the credit of the impacted bond. If the event that causes distress does not impact the manager’s opinion of the holding, believing the company can still meet their obligations, the manager may elect to keep the holding since the client would still receive the associated cash flows. Beyond that, the decision to hold, sell, or buy more would also depend on how much time is left on the bond and the availability of replacement opportunities with similar yield characteristics.
Ultimately, while an Income manager remains focused on cash flows, a Total Return manager places more emphasis on the potential for price appreciation or depreciation.
Choosing Between Total Return and Income
As mentioned, we believe that choosing between a Total Return and an Income strategy depends on the client’s stated objectives. If a client’s goals are to produce steady cash flows needed to support their retirement income needs—and that is what they prioritize above all else—then an Income approach may make the most sense. If a client is willing to assume more risk along the way, which may result in substantial volatility and capital loss in exchange for the possibility of achieving greater long-term growth, then a Total Return strategy could make more sense.
In some cases both goals would apply—an investor might have one set of assets they want to use exclusively for income, and another set of assets they want to devote to growth. In those cases, a ‘bucket’ approach could make sense, where both the Income and Total Return approaches can be applied.
At Roosevelt, we believe the investment decision ultimately comes down to answering the question, what are the client’s primary goals? We find it useful to obtain the most specific answer, and then let that serve as the basis for an appropriate recommendation.
This information is intended solely to report on investment strategies and opportunities identified by Roosevelt. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Please contact us at 646-452-6700 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions, or if you would like to request a copy of our Code of Ethics. Our current disclosure statement is set forth on our Form ADV Part II, available for your review upon request, and on our website, www.rooseveltinvestments.com.