Brian Meath, Managing Director, Senior Portfolio Manager

Samuel Pittman, Head of Asset Allocation, Advisor & Intermediary Solutions


When seeking income in retirement, or in general, individuals and financial advisors typically choose between two overarching approaches: total-return or yield-oriented. Despite the advantages of a total-return approach, many retirees and their advisors consistently show preference for a yield-oriented approach. Yet, while all investments have risks, if not done properly, this latter approach may lead to undue additional risks while trying to achieve investor retirement objectives.

Instincts for yield-oriented investing

Reasons for a preference towards a yield-oriented approach vary, but the common core motivations appear to be simplicity and perceived peace of mind. Instinctually, many investors want to satisfy their need for income by loading a portfolio with yield-oriented products, using the resulting income stream to simulate a paycheck. By leaving their principal untouched, investors feel like they are ensuring enough money to support lifelong spending. It’s a simple, comfortable solution to a complex issue. Unfortunately, it has the makings of a fallacy that could produce some very unpleasant financial surprises.

For academics and others in the industry it will come as no surprise that our own research demonstrates that a total-return portfolio can be more efficient and can result in a higher overall return. Our studies show that portfolios with a yield objective of up to 3.5% are not impaired, but that total expected return often declines when yield surpasses 3.5%. The decline occurs at an increasing rate as forecasted yield increases to 5% and beyond. That’s because a yield-oriented portfolio can introduce constraints on the portfolio’s design, construction and management processes.

Yield-oriented investing, when not done in a balanced way, may impose limits on the range of potential investment choices and asset allocation overall. Thus, generally, the higher the yield constraint, the greater the proportion of the portfolio invested in debt securities1 at the expense of other growth assets. Additionally, reaching for too much yield can erode the portfolio’s capital base. For example, a high-yield bond could produce a solid yield, but the underlying capital base could depreciate due to downward price movements as interest rates rise or as credit spreads expand. Also, if yield does not allow for capital appreciation, the portfolio’s real capital base will gradually erode due to inflation. Such a result can likely lead to unsustainable or lower income in the future, therefore eroding an investor’s chances of achieving their income objectives in retirement.

As a result, Russell Investments tends to prefer total-return portfolios. However, we also acknowledge that some investors will still prefer a yield-oriented approach. That’s why our organization also offers some income portfolios that are designed to seek a balanced approach to both yield and total return objectives as part of a responsible total-return strategy.

Irresponsible vs. responsible yield

Adding a requirement that a significant proportion of a portfolio’s return comes from yield can increase the complexity of managing an investment outcome. It becomes harder to diversify a portfolio with such requirements. This, in turn, often drives up risk and typically lowers potential returns. Unfortunately, many yield-seeking investment products ignore these additional complexities to pursue yield at all costs. In our view, this represents an irresponsible investment strategy.

Worse yet, the yield chase may provide a false sense of security for retirees. Traditional sources of yield, such as money market accounts, U.S. Treasuries and investment-grade fixed income assets are typically associated with low volatility. However, during periods of low interest rates, investors often want to stretch beyond such traditional sources, to seek higher-yielding securities within the capital markets. These higher-yielding securities often bring much higher volatility and significant downside risk. For example, the yield on U.S. high-yield bonds was 6.6% as of March 2015. But, during the financial crisis, the worst 12-month return for the asset class in the last 20 years was minus 31.2%2. By comparison, the worst 12-month return for a typical bond portfolio, like the Barclays U.S. Aggregate Bond Index, over the last 20 years, was only minus 3.7%3.

We routinely see yield-oriented investment products, such as global high yield, with as much as 60% of assets invested in a single asset class. At the extreme, we have seen multi-asset, yield-seeking funds in which the fixed income portion of the fund was more than 80% invested in high yield4. Such an extreme lack of diversification requires greater timing skill to avoid an eventual downturn, plus it exposes the portfolio to a level of risk that can often be higher than many investors are willing to tolerate. This is why we advocate a multi-asset diversified approach overall to help portfolios meet the objectives of their investors.

Seeking irresponsible yield could ultimately result in a declining income stream due to compromising the portfolio’s capital base. On the other hand, Russell believes investors who seek a responsible yield through diversification using a multi-asset investment strategy can potentially enjoy a more sustainable future income stream and fewer sleepless nights. Of course, diversification, like any investment strategy, does not assure a profit nor protect against potential losses in declining markets.

Responsible yield can help lead to sustainable income

We believe that investors with a preference for yield need not risk paying such an exorbitant cost. Responsible yield encourages a level of yield that may not materially reduce a portfolio’s total expected return for the risk taken—and has a higher probability of providing sustainable income. To help achieve a responsible yield-oriented portfolio, we recommend four key areas of focus:

  1. Balance: Today’s income needs must be balanced with the portfolio’s longer-term objective of growth for tomorrow.
  2. Diversification: Make sure a portfolio relies on a mixture of strategies, asset classes and globally diverse investments.
  3. Risk: Beware of overreaching for yield. The appropriateness of risk should be aligned to an investor’s individual ability to tolerate and weather risk.
  4. Adaptability: Yield-producing assets may require dynamic asset-allocation adjustments. Be sure that such a portfolio has the ability to be adjusted with appropriate frequency.

How far can one push to increase yield before it starts having a negative impact on total return, the portfolio’s growth rate and, ultimately, its ability to generate sustainable future yield? The following chart demonstrates both irresponsible and responsible yield, according to our analysis.

This chart shows a hypothetical comparison of a yield-chasing portfolio vs. a responsible yield portfolio, both seeking to help provide sustainable income.

How can investors build portfolios aimed at producing sustainable income? We advocate a design-construct-manage framework:

Design an asset allocation that has a responsible level of yield

In the design phase, the objective is to build an asset allocation that meets the investor’s objectives in total. However, the overall design should account for both risk and return aspects of the investor’s situation by balancing the desire for income with the need for continued future growth and sustainable income. Two tenets of responsible design include:

  • Avoid pulling out too much income, therefore eroding the portfolio’s capital base;
  • Avoid creating too much cost in terms of reduced total return, not just expense.

Constructing a responsible yield-oriented portfolio

A responsible yield portfolio requires diversification across multiple sources of income. For example, fixed income exposure can be diversified across different types of high yielding fixed income securities (emerging market debt and bank loans) which have different risk profiles. This can help investors better withstand market stresses compared to investors who have exposed themselves to singular segments of the markets.

Managing a responsible yield-oriented portfolio

It can be. As demonstrated above, some investors who chase yield may be at risk of making detrimental asset allocation decisions. Still, yield-oriented portfolios do have a legitimate place within an outcome-driven investment strategy. To avoid unnecessary risks to future income streams, we advocate a responsible hunt for yield—a discipline that helps increase the probability for sustainable income.

So is a yield-oriented investing irresponsible?

It can be. As demonstrated above, some investors who chase yield may be at risk of making detrimental asset allocation decisions. Still, yield-oriented portfolios do have a legitimate place within an outcome-driven investment strategy. To avoid unnecessary risks to future income streams, we advocate a responsible hunt for yield—a discipline that helps increase the probability for sustainable income.

1 Definition of debt security, from Investopedia.com: Any debt instrument that can be bought or sold between two parties and has basic terms defined, such as notional amount (amount borrowed), interest rate and maturity/renewal date. Debt securities include government bonds, corporate bonds, CDs, municipal bonds, preferred stock, collateralized securities (such as CDOs, CMOs, GNMAs) and zero-coupon securities. Also known as "fixed-income securities."

2 U.S High Yield: Barclays U.S. High Yield Index as of March 2015.

3 Barclays U.S. Aggregate Bond Index as of September 2012 and September 2013.

4 Morningstar® Big Six Data report as of March 31, 2015.


Disclosures

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Diversification does not assure a profit and does not protect against loss in declining markets.

Investing for yield involves a number of risks, including those associated with equities, bonds and derivatives.

Stock/Equity investors should carefully consider risks such as market risk when investing. There are no guarantees when it comes to individual stocks. Any stock may go bankrupt, in which case your investment may be worth nothing.

Bonds involve risks such as interest rate, credit, default and duration risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield ("junk") bonds or mortgage-backed securities. Investments in derivatives may cause the investors losses to be greater than if he/she invests only in conventional securities and can cause the returns to be more volatile.

The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.

2015 Morningstar®. All rights reserved. The information, data, analyses, and opinions contained herein (1) are proprietary to Morningstar, Inc. and its affiliates (collectively, Morningstar), (2) may not be copied or redistributed, (3) do not constitute investment advice offered by Morningstar (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) are not warranted to be accurate, complete, or timely. Morningstar shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, this information, data, analyses or opinions or their use. Past performance is no guarantee of future results.

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First used: July 2015

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