Income-oriented investment strategies have returned to favour over the past few years with a strong trend towards cash and bonds that have delivered positive results since the GFC with little or no capital risk, according to MLC’s Michael Karagianis.

Income-based investment strategies have in part become the “new black” because of a period of disappointment with traditional investment approaches that have high equity exposure.

Demographic shift

What may give this investment fad durability could be the fundamental impact of evolving demographics. Australia has an increasingly aging population. A large bulge of the Australian population is heading into retirement.

Some argue that retirement investment strategies should be rich in traditional growth assets aimed at maximising long-term returns.

However, the argument for growth-oriented strategies may be undermined in periods where investment returns are sub-par and volatility is high.

A major negative wealth shock for investors a few years either side of retirement can produce a catastrophic loss of lifestyle in retirement; with no employment income, the investor can’t top up their eroded retirement savings.

Cash, bonds and dividends deliver

Many investors have found favour in income-based investing. The objective of this approach is to deliver a stable and sufficient income stream while at the same time reducing underlying capital volatility. In reality this sound very much like the capital stable strategies that gained popularity in the early 1990s.

With term deposits and fixed income funds having delivered returns of seven per cent to 10 per cent or higher over the past two years with negligible capital volatility, it seems to be a perfect solution to the problem.

If such returns could be sustained long-term, then this could prove to be the ideal investment solution for the current environment. Unfortunately, it’s highly unlikely that cash and bond-based investments alone will generate this level of returns on a sustainable basis in the future.

Average term deposit rates have fallen below six per cent following interest rate cuts by the RBA and fixed income funds are seeing much lower running yields at the moment.

Some investors who, as part of an income strategy, have sought to focus on higher dividend paying share investments, particularly in the Australian share market.

Apart from a higher potential after-tax return, the benefit of a dividend-focused strategy is that dividends tend to grow over time in line with corporate profitability. This growth provides some protection against rising cost pressures.

However, while dividend yields available in the Australian market are attractive, capital volatility has also been high.

A simple dividend-focused approach to the share market may therefore not always generate attractive total returns.

A more sophisticated approach

There are solutions to this, but they’re likely to require more sophisticated approaches. One answer could be to blend a range of investment strategies that deliver sustainable income returns while actively managing capital risk.

Such strategies are likely to employ a wide diversity of income/return sources to minimise investment risk.

Increased exposure to credit may be extremely useful within such strategies. However, there is a need to both invest in a highly diversified credit portfolio and, to actively manage that risk over a full investment cycle.

It could also be possible to further mitigate risk by employing absolute return approaches. This might also include multi-asset absolute return strategies or equity income strategies, which aim to generate a more stable total return with less capital risk.

Lastly, a strategy seeking more stable returns and lower capital risk should ideally hold a reasonable exposure to international assets.

In short, the cash and bond strategies adopted by investors in the aftermath of the GFC to seek higher income returns with relatively low risk are unlikely to deliver the required level of returns in future. Nor are they likely to provide the necessary total returns (income and capital gains) to sustain retirement lifestyles longer term.

It is likely more sophisticated approaches, which aim to meet this investment requirement, are going to be needed in future.

Michael Karagianis is an investment strategist at MLC.

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