One recurring theme that investors seem to be uncomfortable about is the fluctuation in the asset values of their funds’ investments. Time and again, investors – mainly those seeking income – lament that over time they feel that their portfolio value seems to decline compared to their invested capital.
In many cases investors outright ignore the income generated, and point out that they expect their capital to increase as well over time. Despite the fact that clients at the start of the investment would have confidently declared at the outset that they are investing for the long term and are able to withstand fluctuations in capital, it is not uncommon, to see investors become concerned about fluctuations in their investment values. This concern arises when clients interpret a sustained period of market turmoil, and they extrapolate that their investment will sustain severe losses in the long term.
So what is the issue of this malaise? Is it possible to generate income and growth at the same time? What are the factors that lead to the erosion of the investors’ confidence? First it is important to understand that generally growth generating investments and income generating investments, are fundamentally different in their nature. Growth assets are normally associated with equity and other risk bearing instruments, while income assets are associated with debt or instruments representing a stream of cash flows.
In general terms this means that income seeking investors will have higher allocations in their portfolio towards income assets while growth-seeking investors will tend to have a greater portion of their investments in growth assets. By now it should start to become rather clear that an income investor, who will be extracting the income from his portfolio on a regular basis, will have a limited opportunity to experience increases in his capital value compared to the growth investor, or other debt instrument investors who decide to accumulate their incomes.
Despite the limitations, income-seeking investors could still experience increases in their portfolio values through the re-pricing of debt instruments in periods of monetary easing, credit quality upgrades, profit taking and increased asset flows (demand and supply). These factors are potential sources for fund managers to generate alpha, within an income portfolio.
However, in pursuing this possibility fund managers could expose investors to undue risk, as despite all the information at hand, the fluctuations in investments do follow a form of random walk.
The main driver of asset class growth in the previous years has been the increased demand for debt instruments. This makes existing portfolios of bonds less likely to experience capital growth. However, for investors demanding income, investing in fixed income securities is mainly the way to generate a regular level of return, with relatively lower levels of volatility. Additionally growth asset classes tend to carry a higher level of volatility which may not be adequate especially for clients who are in their retirement and dependent on income. This comes to the argument of adjusting customers’ expectations.
It is commonly agreed among financial advisors, that many investors do not appreciate the effects of growth versus income. Locally the idea of investing for a regular stream of income, is predominant over the idea of investing for long-term growth. Instead of basing this decision on their actual needs investors tend to opt to receive income, despite the fact that this would not be required until the investor actually retires. By taking this path these investors are foregoing many benefits enjoyed by growth-oriented investors.
First they tend to miss out on what Albert Einstein called the most powerful force of the universe, compound investing. This is the concept of reinvesting proceeds from investment accumulating capital. Taking for example an investment which pays a regular income of four per cent p.a, compounded over 10 years the investment generates a total return 48 per cent (not 40 per cent) or eight per cent in excess of the income. The same investment compounded for 20 years would generate a total return of 119 per cent (not 80 per cent) or 39 per cent in excess of the income. Compounding is considered as the strongest contributor of long-term investment returns which together with investment selection can make the whole difference in a portfolio’s long term outcome.
The second factor, which is also important is the ability to tap into higher growth or income generating assets. For example returns on the MSCI World Index, over the previous 10 years generated an annualised total return of 13.05 per cent p.a as at end of year 2018. Conversely, income generating asset classes such as the Barclays High Grade US Bond Index generated a total return of 3.87 per cent p.a over the same period. The implication that this second factor has is that investors who are seeking to generate a stable income, and in turn seeking less volatile assets will be penalised in the form of lower total return generation, as opposed to an investor who is able to tap into more growth asset classes as he is able to accumulate growth for the long term.
Finally, there is the benefit of being able to defer paying the taxman. Income or capital gains paid to investors is taxed, while, if left to accumulate within a fund this is delayed, allowing growth and compounding on the full income which would include that component that would have otherwise been paid as tax. Investors, especially those who are still earning income from their employment, could seldom benefit from this by accessing their investments at a later stage in life when they need to supplement their lower incomes in retirement, taking advantage of deferring tax.
It is true, that not all investment options are open for all investors, and changing needs play a large factor in the recommendation of investments. It is of paramount importance to understand what you as investor need from your investment, in the different stages of life. Income or growth should not be a one-way street, as investors could exploit the benefits of the two strategies in different proportionability. The right balance in investments is a matter of choices, understanding markets, timing and strategy. With the right advisor by your side you can optimise your future wealth.
This article was prepared by Daniel Gauci HnD Management, CeFa Investments, an investment advisor at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The company is licensed to conduct investment services by the MFSA and is a member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on 2122 4410, or e-mail daniel.gauci@jesmondmizzi.com.