Why individuals should follow the lead of endowments and foundations and focus on total return investing.
Why individuals should follow the lead of endowments and foundations and focus on total return investing.
In this episode, you’ll learn:
- What are the laws and principles that instituional funds, such as endowments, follow when they invest.
- What is the Uniform Prudent Management of Institutional Funds Act
- What type of due diligence should investors perform.
- What factors should both institutions and individuals consider when investing.
- What is an investment policy.
- What are the 7 things corporations can do with their earnings.
- Why many corporations buy back shares instead of increasing dividends.
- How the risks of income investing include concentration risk, valuation risk, interest rate risk and leverage risk.
Show Notes
Uniform Prudent Managment of Institutional Funds Act
Summary Article
What Are the Risks of Income Investing
Investors, especially retirees, need to decide how focused they want to be on generating income with their investments versus generating a total return, which includes both income and capital appreciation.
Most investors get income from dividends and earned interest. With interest rates and yields near historical lows, it has been difficult for retirees and other investors to generate a sufficient return strictly from income.
In some cases, these income-oriented investors are unwittingly taking significant risk in order to generate more income.
Income Investing Risks
What are these risks?
They include concentration risk, valuation risk, interest rate risk and leverage risk.
Concentration Risk
Concentration risk is having too much exposure to a given sector or asset type.
For example, some dividend oriented stock funds or ETFs can generate a higher dividend yield by concentrating their assets in certain sectors and industries, such as the financial and utilities sectors that typically have higher dividend yields.
Investors pursuing dividend-oriented stock strategies should make sure the fund or ETF they are using is diversified among many different sectors and industries.
Likewise, investors should make sure they are not overly dependent on one asset class such as real estate investment trusts (REITs) to generate income. REITs are publicly traded securities that invest in real estate.
Valuation Risk
Valuation risk is when certain income strategies become so popular that investors push up valuations to levels that are unreasonable and can potentially lead to lower future returns.
For example, the yield on real estate investment trusts as measured by the NAREIT dividend yield is currently around 3.8%, its lowest level going back to at least 1975.
Meanwhile, according to Lazard Asset Management, REITs are trading at 20 times funds from operations (“FFO”). FFO is a measure of REIT earnings excluding the impact of depreciation. A price-to-FFO of 20 is well above the long-term average of 16.
Finally, REITs are trading at a premium of 11% to the value of the underlying real estate owned by the REITs. Historically that premium is 3.5%.
Asset classes can stay overvalued for long periods of time, but the historical low yields on REITs combined with high valuations could lead to lower returns for this income strategy on a going forward basis and perhaps outright losses if valuations return to normal.
Interest Rate Risk
Interest rate risk is defined as the risk of capital loss to an asset class when interest rates rise. We usually think of interest rate risks as applying to bonds. When interest rates increase the value of bonds go down.
The longer the maturity of the bond the more it goes down when interest rates climb.
Interest rate risk also applies to non-interest bearing income vehicles, such as REITs and preferred stocks. These yield oriented asset categories compete with bonds to attract the attention of income seeking investors.
Consequently, when interest rates rise the yields on REITs, preferred stocks and other dividend paying strategies usually increase in tandem.
Given these strategies don’t automatically increase the absolute dollar amount of their dividends when interest rates rise, the only way their yields can increase is if their prices fall.
Furthermore, unlike bonds, REITs and preferred stocks don’t have maturities. That means they essentially act like very long-term bonds, which means their prices are even more sensitive to fluctuation in interest rates.
Leverage Risk
A final risk to consider when investing for income is leverage. A number of income strategies, such as closed end funds, are able to generate high yields by using leverage.
Closed end funds are commingled investment vehicles that trade on a stock exchange and have a set number of shares.
Many of these funds will borrow money in order to buy additional yield oriented securities such as REITs and preferred stocks. The use of leverage can boost yields, but it also can increase volatility.
Because closed end funds have a set number of shares, their prices can differ from the value of the underlying securities, which means the prices can trade at a discount or premium to the net asset value.
During a period of market turmoil the price of these yield oriented closed end funds can plummet as the use of leverage magnifies losses that is further compounded by fearful investors selling their shares which leads to a greater drop in prices as the discount to net asset value widens.
A Duel Focus
Prudent investors employ both income and total return strategies in their portfolios. Income investing can be rewarding as long as investors are aware of and seek to mitigate concentration, valuation, interest rate and leverage risks.
