Protect Your Money to Make Money
Diversification is still considered to be the most effective way to manage risk within a portfolio, but it’s not the only way.
In past Hot Tips, I have touched on the benefits of many other strategies that can help investors to navigate volatile market conditions and to preserve capital. Among them was dollar cost averaging, currency hedging, investing long-term and avoiding market timing.
So as we finish 2010 with the threat of a double-dip recession in the US and with Europe remaining on very shaky ground, make the most of your holiday break to take stock and rethink your defensive strategy for 2011.
It’s a new year, so why not take a fresh approach?
The double digit returns from Australian equities experienced during 2003 – 2007 are a thing of the past, so investors should expect more moderate returns going forward.
More importantly, as the performance of Australian equities normalises over the next few years, income will become significantly more important for two reasons:
- Income can act as a defensive investment to help smooth out some of the volatility from growth assets; and
- Income producing investments are likely to make a more significant contribution to total return than growth assets.
Time to go looking for income
Managed funds are a pass-through trust structure, which means that any income that is generated from the assets within the portfolio, has to be paid out to unitholders.
As such, funds that specifically seek out assets that generate income can be a great way to protect capital, stabilise your portfolio and ensure that you get a little something back from your investments.
Income producing investments are also more reliable than growth assets and can also help to dampen the effects of volatility of your growth assets simply by providing a steady source of income back into the portfolio.
Show me the money
To show you just how important income can be, I have selected a range of blended large cap Australian equity funds available via RaboDirect and reviewed their performance over the past three years. More specifically, I have looked as the income return at a proportion of their total return.
Figure 1: Performance Comparison of Large Cap Australian Equity Funds
Source: Morningstar Research effective 31 October 2010.
Total Returns are generated from the combination of Growth Returns and Income Returns.
Growth Returns refer to the appreciation or depreciation in the performance of the funds and the value of the underlying investments.
Income Returns include dividends and other distributions generated from the investments within the portfolio.
Figure 2: Income Return as a percentage of Total Return
Source: Morningstar Research effective 31 October 2010.
As you can see from the above table, the Income Return generated from this selection of Australian Equity funds has significantly shifted over the past three years and is now the principle contributor to Total Return.
In some instances, such as the UBS Australian Share Fund, income generated via dividends from the stocks within the portfolio have delivered more than twice the Growth Return which represents the appreciation (or in this case depreciation) in the value of the underlying stocks.
Figure 3: Growth and Income Return 1 Year
To give you an indication of just how important Income Return can be, the below chart presents the percentage contribution of Growth Return and Income Return over the past year.
Of particular note is the positive contribution of Income Return for the UBS Australian Share Fund.
Source:Morningstar Researcheffective 31 October 2010.
Where can I get me some of that?
Many of the Australian equity funds on the RaboDirect investment menu are growth orientated, but the
BT Imputation Fund and the Vanguard Australian Shares High Yield Fund are both focused on selecting stocks from the S&P/ASX 200 and 300 indices that pay high dividends and allow funds to deliver a tax effective income stream.
Of course, you could also select one of the many fixed income funds available. In this instance, you not only get the benefit of regular income, but these funds are an excellent way of preserving capital and mitigating volatility.
So don’t underestimate the importance of income within your portfolio. It can not only help protect your portfolio and dampen volatility of your growth investments, but it can also have a significant impact upon the total return on your investments.
Happy investing and enjoy the holiday season!
Professional advice is recommended for all financial and strategic decisions. However, this information is not professional advice and has been prepared without taking account of an individual's objectives, financial situation or needs. Because of this, an individual should first consider the appropriateness of this information, having regard to their objectives, financial situation and needs.
The persons involved in its preparation and distribution and their related persons disclaim all liability for any loss or damage suffered due to the use or otherwise of the information. The views and opinions expressed in this presentation are those of the author and do not necessarily represent the views and opinion of Rabobank Australia Limited.
