Premier Miton Investors multi-asset manager David Jane has highlighted what he sees as a common misconception investors have around income investing.
In a commentary note this week, Jane (pictured) said that income strategies are often perceived as higher risk than total return based ones, perhaps unfairly.
“This appears to be a result of some significant historic failures of particular strategies but is not evidenced by the broader data,” Jane said. “This is an important consideration for investors in drawdown, especially for the majority who are drawing more than the natural income from their portfolio.
“People’s opinion of income strategies has been clouded by the impact of the Global Financial Crisis where banks, in particular, did very badly. In most historic drawdowns, income and value strategies have been defensive.”
Jane said the key risk for investors in retirement is sequencing risk. This refers to poorly-timed withdrawals from a retirement account damaging overall returns.
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“The impact of large falls in capital values, when a portfolio is in drawdown, can be very significant,” he noted. “Losses at any point in retirement will materially reduce how long the portfolio lasts. Losses are locked in by the need to be continually selling assets to fund income needs.”
Jane explained this can be mitigated by only drawing the natural income, but this is not possible for the vast majority of retirees.
Many advisers therefore hold between one and three years’ spending needs as cash. Jane said while it does reduce overall portfolio risk, it has a significant negative impact on expected returns.
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“When considering funds or other investment products, not only is expected total return relevant, but the pattern of returns is equally important,” he explained. “A highly volatile strategy may be appropriate in accumulation, where weakness provides opportunity to invest at lower prices, but in retirement it might be inappropriate. In particular, downside volatility is especially important for post retirees.”
Sortino ratio is key
Given all this, Jane highlighted the Sortino ratio’s crucial role in managing retirement accounts. It measures returns proportionate to downside risk or volatility. This contrasts with the Sharpe ratio, which measure returns relative to volatility on the upside and downside.
“This is where income strategies can come into their own. While investors are attracted to high returns, in drawdown this is not the whole story. When units are being encashed on a regular basis, Sortino ratio is at least as important. Well run income and value strategies are the majority of funds with positive Sortino ratios, for example, better upside participation than downside in the IA 20-60% shares sector.”
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