Unleash the potential of a total return approach to generating portfolio distributions

The following article was originally posted on the?Mercer Yield Point Blog .?You can find this article along with more wealth news content?here .?

By Steven Keshishoghli, CFA Chartered FCSI, Senior Researcher

If you are a discretionary investment manager contemplating the best route to generating portfolio distributions in the current economic climate, you have two approaches to pick from – natural income and total return. We make the case for considering total return approach, setting out the pros and cons, and why we believe the benefits may outweigh the drawbacks.

In the pre-Global Financial Crisis (GFC) era, the natural income approach was a reasonably reliable one for managers to use – to provide clients with sufficient income to cover their needs. But the world has changed since then. Now, with the moribund recovery in interest rates, discretionary investment managers are being forced to turn to higher-yielding (more risky) assets to generate required returns.

The selection of available investments has also narrowed, which can limit diversification options. That too can lead to greater risk, as well as potentially diminishing managers’ ability to take advantage of market opportunities.

Could mangers avoid these issues adopting a total return approach?

Know the potential benefits

As we’ve already highlighted above, using a natural income approach can?limit client distributions to the amount of income generated by their portfolio. A total return approach, by contrast, can use both the income and capital gains generated by the portfolio assets to satisfy?client distribution requirements. And it offers five potential benefits.

1. An ability to invest more tactically and take advantage of a wider range of market opportunities.
2. The opportunity to invest in lower-yielding assets, such as international stocks and alternative investments.
3. Greater portfolio diversification, with exposure to a broader range of assets and sectors.
4. Less need to focus only on higher-yielding assets, which may not represent the best investment opportunities at any given time. A discretionary investment manager that focuses on obtaining income at all costs may be forced to adopt a suboptimal asset allocation strategy.
5. The portfolio may be in a better position to preserve its real value over the longer term, as some investments providing higher yields might be less productive in terms of capital growth.

Understand the drawbacks

A total return approach is not all plain sailing, though. So, it’s vital for discretionary investment managers to be aware of the disadvantages too.?

First, if a portfolio has enjoyed significant capital gains over the years, there is a risk of a manager falling into the trap of over distribution. Yet, distributing the bulk of existing capital gains could conflict with a client’s wish to pass on their wealth to future generations.

Second, allocation to illiquid assets could become disproportionately large. Why is this an issue??Because by their very nature, illiquid assets may not be liquidated in time to meet distribution requirements. Instead, distributions would be financed by the sale of a greater portion of liquid assets.

Another potential red flag of the total return option is that it could lead to managers taking market risk to generate an above-inflation return. And finally, managers should also factor in the potential?impact of a negative return year on distribution levels.

Happily, there are mitigating actions discretionary investment managers can take to minimise these drawbacks.?

How to avoid the pitfalls

To sidestep the risk of over distribution and to preserve the real value of client assets, there is one action discretionary investment managers can consider –do not distribute more than the excess return above inflation generated by client assets.

So, for example, if a portfolio is designed to generate a CPI + 4% return over the long term, limit the average annual distribution to 4% of the value of the assets.

At Mercer, we believe discretionary investment managers should have the necessary governance framework in place to maintain distribution discipline. This can be a simple as limiting distribution to the level of income generated by the portfolio.

Distribution discipline has another potential advantage – it alleviates the risk of portfolios depleting their more liquid assets to meet distributions. That is an important consideration for portfolios that include allocations to private markets.

And what about the argument that managers using the total return approach take on additional market risk to generate an above-inflation return? We think that in the current ultra-low interest rate environment, it is in fact doubtful whether the natural income approach results in a more conservative asset allocation. It may result in a less efficient portfolio; one with a less attractive risk/return profile.

Lastly, to the vexing question of what should happen to distribution levels in a negative return year. In that climate, we believe a prudent approach is to build a reserve of unspent capital gains during the ‘good times’ to help fund client distribution needs during the ‘bad times’. That way managers can enjoy having a capital buffer that can be used to finance discretionary client spending above the annual distribution requirements.

?Tax Note

Any tax implications will depend on a number of variables, such as client type, investment account and geographical jurisdiction. Make sure the approach you choose,?natural?income or total return, provides the highest after-tax distributions. Seek professional advice to understand the full tax implications before making your final decision.?

Which option works for you?