Natural income even for growth investors – has the argument just got stronger?

Steve Hunter, Head of Business Development at Seneca Investment Managers, explores whether investing in income generating investments can make a difference for advisers and their clients ahead of any market downturn.

Growth investing v income investing today?  

This argument is an important one for advisers to consider for their clients.  Retirement saving provisions serve a myriad of needs in later life for people today.  For some it is to partly encash and leave the remainder of their fund to grow.  While for others it is to receive a sustainable return that can meet their spending needs for the remainder of their lives. Advisers should now consider whether natural income can serve both needs, simply reinvesting for growth or taking the natural income for income-based needs.

A key argument on the side of the traditional capital withdrawers or unit encashers is that capital withdrawal gives the investor cash when they want it.  This element of apparent control is attractive as it provides a level of certainty to the investor. Conversely, natural income, may have infrequent pay-outs in different amounts - causing the investor who just wants steady withdrawals some headaches.

However, the sense of control may be illusory.  Encashment may lead to the overall value of a client’s investments falling, especially if encashment happens at a time of low market valuations, thereby shortening the effective life of the portfolio.  The counter argument and big advantage of receiving a natural income is that unlike with encashment, capital remains untouched and the investor receives the true “natural yield” of their investment.  If this option is preferred selecting a fund with a long-term track record of delivering steady regular income is key.

Put another way, the fiduciary manager selling down or liquidating assets from the portfolio may have the propensity to lose the investor money through poor market timing, i.e. selling tomorrow may have been better than selling today.  By accepting a natural income without detriment to capital rather than encashment, the timing issue of selling assets at the wrong time is avoided.  As many advisers will know, taking cash from a portfolio in a falling market has a significant negative impact which is difficult to recover.

So, there’s a trade-off on both sides of the coin, capital withdrawal v natural income. We are of the belief that the natural income argument has become stronger in recent times.  The last decade has seen strong growth in many markets. Indeed, an investor withdrawing part of the capital amount as income has seen no issues as investments in the main have grown year on year.  Generating capital growth has not been a problem in recent times, especially in the era of artificially low and accommodative interest rates. But all good things must come to an end. 

What about growth investors?

For long-term investors with relatively ambitious growth objectives, advisers again may want to consider income funds with accumulation shares as over time the effect of “compounding” should significantly boost investment pots, arguably more so than investing in growth stocks alone.

What about the next 10 years?

An increasing number of market commentators and investment experts believe we are approaching the end of the bull-market run. If correct, where does this leave growth investors as markets deliver lower, sideways or perhaps even negative returns? = Understanding that growth stocks may take the biggest hit to value when the market falls, could higher-yielding assets - act as a cushion in more difficult times. 

The sustainability of income reinvested for growth?

Let’s use a simple example to paint this picture. Stock A has a well covered 5% dividend yield while stock B has only a1% dividend yield.  Both stocks generate zero increase in share-price over 12 months but what does the investor receive?  In this example the investor would be 4% better off for having selected the higher yielding stock for its pay-out ratio and value characteristics rather than the lower yielding stock. It’s a no brainer (appreciating that individual clients tax positions must also obviously be considered.)

Does the policy of income reinvestment, symptomatic of accumulation shares in income funds, give the potential for greater return in the investment markets of the next decade? Well it’s difficult to predict, but with more value companies  appearing in the market this could certainly be a future consideration for growth investors too.

Considerations for advisers: accumulating income investments for growth clients?

As the business cycle turns and capital market expectations change, advised clients may be better off being on the right side of the market trade-off; this may mean having your clients’ portfolios exposed to  income yielding value shares, offering the benefits of a natural yield– rather than to  lower yielding stocks relying on capital growth that has been the key feature of the last decade.

Issued by Seneca Investment Managers 

The views expressed are those of Steve Hunter at the time of writing and are subject to change without notice. They are not necessarily the views of Seneca Investment Managers Limited and do not constitute investment advice. Whilst Seneca Investment Managers has used all reasonable efforts to ensure the accuracy of the information contained in this communication, we cannot guarantee the reliability, completeness or accuracy of the content. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.  Seneca Investment Managers Limited (0151 906 2450) is authorised and regulated by the Financial Conduct Authority and is registered in England No. 4325961 with its registered office at Tenth Floor, Horton House, Exchange Flags, Liverpool, L2 3YL. FP19 297