Retirement Ready Income Programs

The Total Return Shell Game

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No "Interest Rate Sensitive" Security is an Island...

Just what is this "total return" thing that income portfolio managers like to talk about, and that Wall Street uses as the performance hoop that all investment managers have to jump through? Why is it mostly just smoke and mirrors? Here's the formula:

  • Total Income + (or -) Change in Market Value - Expenses = Total Return --- and this is supposed to be the ultimate test for any investment portfolio, income or equity. 

Applied to Fixed Income Investment Portfolios, it is useless nonsense designed to confuse and to annoy investors. How many of you remember John Q. Retiree? He was that guy with his chest all puffed up one year, bragging about the 12% "Total Return" on his bond portfolio while he secretly wondered why he only had about 3% in actual spending money.

The next year he's scratching his head wondering how he's ever going to make ends meet with a total return that's quickly approaching zero. Do you think he realizes that his actual spending money may be higher? What's wrong with this thinking? How would the media compare mutual fund managers without it?

Wall Street doesn't much care because investor's have been brainwashed into thinking that income investing and equity investing can be measured with the same ruler. They just can't, and the "total return" ruler itself would be thrown out with a lot of other investment trash if it were more widely understood.

If you want to use a ruler that applies equally well to both classes of investment security, you have to change just one piece of the formula and give the new concept a name that focuses in on what certainly is the most important thing about income investing --- the actual spending money.

We’ll identify this new way of looking at things as part of “The Working Capital Model” and the new and improved formulae are:

  • For Fixed Income Securities: Total Cash Income + Net Realized Capital Gains - Expenses = Total Spending Money!
  • For Equity Securities: Total Cash Income + Net Realized Capital Gains – Expenses = Total Spending Money!

Yes, they are the same! The difference is what the investor elects to do with the spending money after it has become available. So if John Q's Investment pro had taken profits on the bonds held in year one, he could have sent out some bigger income payments and/or taken advantage of the rise in interest rates that happened in year two.

Better for John Q, sure, but the lowered "total return" number could have gotten him fired. What we’ve done is taken those troublesome paper profits and losses out of the equation entirely. "Unrealized" is "un-relevant" in an investment portfolio that is diversified properly and comprised only of investment grade, income producing securities.

Most of you know who Bill Gross is. He's the fixed Income equivalent of Warren Buffett, and he just happens to manage the world's largest "open ended" bond mutual fund. How was he investing his own money during other interest rate cycles?

Well, according to an article by Jonathan Fuerbringer in the Money and Business Section of January 11, 2004 New York Times, he's removed it from the Total Return Mutual Fund he manages and moved it into: Closed End Municipal Bond Funds where he could "realize" 7.0% tax free. (Must have read "The Brainwashing of the American Investor".)

He doesn’t mention the taxable variety of Closed End Fund (CEF), now yielding a point or two more than the tax free variety, but they certainly demand a presence in the income security bucket of tax-qualified portfolios (IRAs, 401k(s), etc.).

Similarly, the article explains, Mr. Gross advises against the use of the non investment grade securities (junk bonds, for example) that many open-end bond fund managers are sneaking into their portfolios.

But true to form, and forgive the blasphemy if you will, Mr. Gross is as “Total Return” Brainwashed as the rest of the Wall Street institutional community --- totally. He is still giving lip service validity to speculations in commodity futures, foreign currencies, derivatives, and TIPS (Treasury Inflation Protected Securities).

TIPs may be "safer", but the yields are far too dismal. Inflation is a measure of total buying power, and the only sure way to beat it is with higher income levels, not lower ones. If TIPS rise to 5%, REITS will yield 12%, and preferred stocks 9%, etc. No interest rate sensitive security is an Island!

As long as the financial community remains mesmerized with their “total return” statistical shell game, investors will be the losers.

  • Total Return goes down when yields on individual securities go up, and vice versa. This is a good thing.
  • Total Return analysis is used to engineer switching decisions between fixed income and equity investment allocations, simply on the basis of statements such as: “The total return on equities is likely to be greater than that on income securities during this period of rising interest rates.”

You have to both understand and commit to the premise that the primary purpose of income securities is income production. You have to focus on the "Income Received" number on your monthly statement and ignore the others... especially NAV.

If you don’t agree with the next three sentences; if they don't make complete sense: you need to learn more about Income Investing:

  • Higher interest rates are the income investor's best friend. They produce higher levels of spending money.
  • Lower interest rates are the income investor's best friend. They provide the opportunity to add realized capital gains to both the total spending money and total working capital numbers.
  • Changes in the market value of investment grade income securities, Yogi says, are totally and completely irrelevant, 97% of the time.

 
Retirement Ready Income Programs
2971 Maritime Forest Drive
Johns Island, SC 29455
Phone (800) 245-0494 • Fax (843) 243-8509
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Please read this disclaimer:
Steve Selengut is registered as an investment adviser representative. His assessments and opinions are purely his own. None of the information presented here should be construed as an endorsement of any business entity; the information is only intended to be educational and thought provoking.

Please join the private article mailing list or Call 800-245-0494 for additional information

Risk Management: Income, 401k, and IRA Programs

Take a free tour of a professional investment managers' private SEP IRA program during ten years surrounding the financial crisis:

CLICK HERE

In developing the investment plan, personal financial goals, objectives, time frames, and future income requirements should all be considered. A first step would be to assure that small portfolios (under $50,000) are at least 50% income focused.

At the $100,000 level, between 30% and 40% income focused is fine, but above age 50, the income focus allocation needs to be no less than 40%... and it could increase in 10% increments every five years.

The "Income Bucket" of the Asset Allocation is itself a portfolio risk minimization tool, and when combined with an "Equity Bucket" that includes only Investment Grade Value Stocks, it becomes a very powerful risk regulator over the life of the portfolio.

Other Risk Minimizers include: "Working Capital Model" based Asset Allocation, fundamental quality based selection criteria, diversification and income production rules, and profit taking guidelines for all securities,

Dealing with changes in the Investment Environment productively involves a market/interest rate/economic cycle appreciation, as has evolved in the Market Cycle Investment Management (MCIM) methodology. Investors must formulate realistic expectations about investment securities--- by class and by type. This will help them deal more effectively with short term events, disruptions and dislocations.

Over the past twenty years, the market has transitioned into a "passive", more products than ever before, environment on the equity side...  while income purpose investing has actually become much easier in the right vehicles. MCIM relies on income closed end funds to power our programs.

To illustrate just how powerful the combination of highest quality equities plus long term closed end funds has been during this time... we have provided an audio PowerPoint that illustrates the development of a Self Directed IRA portfolio from 2004 through 2014.

Throughout the years surrounding the "Financial Crisis", Annual income nearly tripled from $8,400 to $23,400 and Working Capital grew 80% $198,000 to $356,000.

Total income is 6.5% of capital and more than covers the RMD.

https://www.dropbox.com/s/b4i8b5nnq3hafaq/2015-02-24%2011.30%20Income%20Investing_%20The%206_%20Solution.wmv?dl=0

Managing income purpose securities requires price volatility understanding and disciplined income reinvestment protocals. "Total realized return" (emphasis on the realized) and compound earnings growth are the key elements. All forms of income secuities are liquid when dealt with in Closed End Funds. 



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Please read this disclaimer:
Steve Selengut is registered as an investment advisor representative. His assessments and opinions are purely his own and do not represent the views of any other entity. None of his commentary is or should be considered either investment advice or a solicitation of business. Anyone seeking individualized investment advice should contact a qualified investment adviser. None of the information presented in this article is intended to be or should be construed as an endorsement of any entity or organization. The reader should not assume that any strategies, or investments mentioned are any more than illustrations --- they are never recommendations, and others will most certainly disagree with the thoughts presented in the article.