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By Josh Charlson, CFA | 06-13-2013 01:00 PM

The Importance of Total Return

As rates remain low, many investors overlook the risks of higher-yielding fixed-income assets; instead, they should maintain low-cost, well-diversified portfolios, says Vanguard's Fran Kinniry.

Josh Charlson: Hi. I’m Josh Charlson with Morningstar. We’re here at the Morningstar Investment Conference. I’m going to be talking about one of the most troubling issues for investors today, and that is what to do about the low-yield environment. To join us we have Fran Kinniry from Vanguard. He is a principal in the investment strategy group at Vanguard, where he oversees a number of their asset-allocation strategies, including their target-date retirement funds and the Vanguard Managed Payout funds.

Fran, thanks for joining us.

Fran Kinniry: Thank you, Josh.

Charlson: So, obviously, it’s a big concern for investors today who need income with the low nominal and real yields, and there is a risk in going out, stretching for yield, going into other asset classes, and looking for longer-duration instruments. And that’s something you’ve written about. So talk to us a little bit about your concerns of those types of steps investors might take.

Kinniry: Sure. Coming out of the global financial crisis, as we all know, the Federal Reserve really lowered interest rates. If you look back over the last 30 years, the yield on a portfolio, a balanced portfolio with stocks and bonds, has typically been above the spending rate of 4%. But as yields have come down dramatically, all of a sudden a balanced portfolio with yields on bonds at 2% and equities at 2%, the yield contribution is right around 2%. So for an investor in retirement that creates this conundrum: "How do I generate enough income to live off of?"

What we’ve seen coming out of that from cash flows is investors really upping the yield of the portfolio. There are a couple of ways they do that: overweight dividend-paying stocks or overweight corporate bonds, high-yield bonds, bank-loan notes, all higher-risk investments. So that’s concerning to us because we see the portfolios actually having more risk today than they had through history, but many investors don’t realize the risk they’re taking.

Charlson: What can investors do who have income needs but may not want to those kinds of risk, or for whom it may not be appropriate?

Kinniry: We’ve been really preaching a concept known as total return, and that is really keep your portfolio, let your investments be the most broadly diversified and low-cost. So costs are going to have a dramatic impact in a low-return world. Think about if the yield of a portfolio is 2% and you’re paying 1% for investments versus only 25 basis points. [Paying only 25 basis points is] adding 75 basis points to your total return and your yield. So it's lowering costs, keeping your portfolio broadly diversified, and using total return. The concept of total return is just spending the amount made from the portfolio rather than the income, and think about that. The last five years, the equity market is up more than 150%, so being able to spend from capital that was made from the capital markets.

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