Investment Outlook - Spring 2017 Edition

Total return investing – the best of both worlds

If you're looking at this and you're an investor gunning for growth stocks then you should definitely keep reading. Equally, all of you income hunters should take note. Building your portfolio with total return in mind gives you the best of both worlds, so why focus on just one? We're taking a closer look at how total return works and how it can benefit you. Let's start with how they're made up.

Total Return = Capital Gain + Investment Income

Investments such as equities, bonds and funds provide returns which consist of two key components. The first is the capital value. The capital value is one that increases or decreases depending on the price of the asset. The second part of the return is income.

Income can come in various forms – equities pay out dividends and bonds make interest payments known as coupons. Many funds also deliver income regularly, because they distribute the dividends and coupons from their underlying assets.

The total amount of value that investors earn from their investments, in other words capital plus income, is called total return. It is important for all investors, whether they are seeking capital growth or looking to draw income from their portfolio, to understand and consider total return.

Why are total returns important?

  • Can better meet investment needs for certain investors
  • Improve portfolio tax efficiency if invested in an ISA or SIPP
  • Can enhance returns across different market environments

Income has always accounted for a meaningful portion of total return. This has particularly been the case during lower-return environments as investors turn to dividends or coupons to generate income.

Dividends

Individual companies have a choice of how best to utilise their earnings, whether they reinvest in the company, pay down debt, buy back shares or return money to shareholders through dividend payments. Typically, more mature companies which produce cash earnings in excess of that required for growth often choose to pay out dividends. 

An attractive feature of investing in dividend-paying stocks is that investors are not solely reliant upon share price appreciation to generate returns – they can also share in a portion of the company’s earnings. Dividends, of course, are not guaranteed. Even if a company has a history of paying them out that may not continue in the future.

Coupons

Bonds (fixed income) are another common source of income for investors. This income comes in the form of a coupon which a bond is required to pay on a periodic basis. These income payments tend to constitute a large proportion of an investor’s total return from bonds, as unlike with equities price appreciation is not the main driver. The stability of their income payments makes bonds less volatile than other income paying assets. 

The bond market is also very diverse, offering bonds with many different characteristics, from usually stable, dependable government bonds to investment grade corporate bonds through to often higher risk, but higher income paying, high yield bonds.

It is important to note that there are different tax treatments for capital gains and income. Capital gains are subject to capital gains tax (CGT) via the investor’s annual tax return (any unused allowance can also be rolled over) while income is taxed at the investor’s marginal rate.

This, though, is where investing via an ISA can come into its own, as this way you are not liable for any further tax on either capital or income from your investments, within the annual subscription limits. In your SIPP (Self Invested Personal Pension) both returns are also tax-efficient.  If you have a drawdown portfolio, capital and income can accumulate tax-efficiently but any drawings out of the portfolio are treated as such for tax purposes, so may alter the way you think about drawing from this portfolio.   

The power of compounding returns

Historically, dividends have made up a significant portion of the total return from equities. If higher returns are your goal, an effective way of achieving this is to reinvest the income from dividends back into the market and make use of the power of compounding.

You can see from the chart below the difference between the returns you would have got from a £10,000 investment in the FTSE All Share index over the last 20 years without dividend reinvestment (£19,235), illustrated in the chart as price return. By comparison, reinvesting the dividends would have delivered a much higher return of £36,769.

The power of reinvesting dividends
Past performance is not a reliable indicator of future returns
Source: Morningstar Direct as at 31st December 2016

For more information on compounding interest and how to regularly invest with us click here.

Investing for total return with a diversified portfolio

History has shown that in periods where stock market performance is either negative or at best moderately positive, such as the early part of the 2000s and again post the 2008 financial crisis, dividend income tends to display a remarkable level of stability and can provide a valuable source of return.

In contrast, while coupon income has historically provided a significant contribution to overall returns from bonds, after the 2008 financial crisis this has started to wane. Interest rate rises, which are likely to occur in the UK at some point, can also have a negative impact on returns from bonds.

The two charts below show the FTSE All Share and FTSE Gilts All Stock returns over the last 20 years, broken down into price appreciation and income. The blue bar shows price appreciation, which can be either positive or negative. The green bar shows the dividend income for shares and coupon income for bonds, which is always a positive number and therefore enhances the total return.

FTSE All Share Return by Year
Past performance is not a reliable indicator of future returns. Note that current yield may not reflect historical yields.
Source: Morningstar Direct to 31 December 2016
FTSE Gilts All Stock Return by Year
Past performance is not a reliable indicator of future returns. Note that current yield may not reflect historical yields.
Source: Morningstar Direct to 31 December 2016

Staying diversified

It’s also important to have a diversified portfolio in terms of the return profiles of the holdings. You should consider the benefits of investments from both a capital return and an income perspective. As the equity market sell off in 2008 illustrated, some stocks can provide valuable stability via dividend payouts at a time when other shares may be plunging in value. The prospect of rising interest rates in the UK means longer-term bonds could perform poorly in capital terms, and their income yields may not be as attractive as stockmarket dividends are.

As well as more traditional asset classes such as equities and bonds, there are others which offer the potential for a combination of income and capital appreciation providing a solid total return. These include alternatives such as property, infrastructure and commodities. Each of these asset classes has a unique risk/return profile – combining a range of them can reduce risk and smooth returns.

A capital growth fund versus an income fund

When considering the difference between investing for capital growth or income, you could consider the BlackRock UK and Schroder Income funds. BlackRock UK has a long-term capital growth focus. The Schroder fund, meanwhile, aims to deliver a good level of income as part of a total return strategy.

Capital growth versus income
Past performance is not a reliable indicator of future returns.
Source: Bloomberg

Similarly, from a more global perspective Baillie Gifford International seeks out companies which are able to generate above average earnings growth, while Artemis Global Income aim to achieve a combination of capital growth and rising income via a global equity portfolio.

Capital growth versus income
Past performance is not a reliable indicator of future returns.
Source: Bloomberg

As always, a portfolio diversified across a range of different geographies and styles will give you the best possible chance of reducing risk and generating a return which fits with your long-term investment goals. When you think of return, remember that it comes from two sources: capital value, and income; and these can have different return profiles during different market conditions.

If you want to maximise your return the clever thing is often to reinvest the income. But when looking at your next investment, make sure you consider the total return.

Looking for more inspiration? Find out what we have to say about the financial sector.

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Important information

The tax treatment of these products does depend on your circumstances and might change.

The information we provide in this Investment Outlook are opinions provided by TD Direct Investing or one of its partners on whether to buy a specific investment. None of the opinions we provide are a personal recommendation, 

Investors should be aware that the value of investments can fall as well as rise, you may get back less than you invested. Past performance is not a reliable indicator of future returns.

If you are unsure about the suitability of a particular investment you should speak to a suitably qualified financial adviser.

Remember that each fund is unique and hence exposed to different levels of risk. Some are relatively low risk, whilst others can be very risky and those will only be appropriate for more sophisticated investors.

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