Not all asset returns are created equal. For this reason it is imperative to understand how the asset classes described above generate their returns. We will first consider the components of total return and how they relate to one another. We will then examine these components of total return in the context of the various asset classes, and determine when it is appropriate to target each return component.
Components of Total Return
Total return is made up of two parts, income and capital gain. Both of these returns often behave independently to one another, and there are often situations where only one of these components exists for a given asset.
With regards to capital appreciation vs income. Income is the money that is received by the asset holder and can be unpredictable (as is the case with equity) or predictable (as is the case with fixed income).
Capital gain is the difference between the buying price and selling price of an asset, which can be a negative number, and thus a capital loss. It is important to understand that these return components make up the total return on investment, and the total return is then used to analyze an asset’s behavior.
Returns of Asset Classes
The income component for an equity investment is the dividend that the company issues to shareholders. Recall that buying a share of a company provides you with a share of the company’s profits and assets. The usual way that a company gives you your share is through issuing a dividend.
Generally the board of directors (discussed earlier) will meet and determine how much this dividend should be, and in some cases there may be no dividend at all. If, for example, the company declares a dividend of 25 cents per share, and you own 100 000 shares at R4.50 a share, you will receive R25 00 (0.25 x 100 000), and the dividend yield would be 5.56% (0.25 / 4.50).
Dividends can be unpredictable in both amount and timing since the profits and any asset sales of the company have a big effect on the size of the possible dividend. For instance, if a company made a loss instead of a profit, it literally may not be able to issue a dividend.
Generally, dividend dates are stated in advance and companies try to be as consistent as possible, but this is not always the case and special dividends may be awarded and long standing dividend payments may be abruptly stopped. The companies try their best though, most of the time, to communicate as timeously and transparently as possible with regards to what shareholders can expect.
Note: there has been a shift in companies behavior over the years to move away from regular dividends to share buy-backs. These share buy-backs have the same economic effect as a dividend but are slightly more complicated in their execution since it results in the shareholder having less shares after the event, and the nature of the return is more capital gain.
The capital gain (loss) component for an equity investment is simply the difference between the price at which the share was sold compared to the price the share was bought.
This is arguably the most significant return component for an equity investment. In some cases investors may think that the price of a share is about to go up significantly, so they buy the share and hold it until the share reaches its target and then sell. This can be a short-term holding period in which no dividend is declared and the total return is made up entirely of capital gain.
Fixed income is a tricky beast and a general impression exists that it’s a boring investment. However, if you are mathematically inclined fixed income can offer extremely lucrative returns.
The reason is because there is money to be made on the regular interest payments, called coupons, as well as the change in bond price that may result in capital gain. A lot of people struggle to understand the workings of a bond, and without going too deep the way a bond functions is as follows.
A company or government may issue a 10 year R1 000 000 face value bond with an annual 5% coupon at a price of R980 000. What this means is:
You can buy the bond for R980 000
The issuer will pay you annual coupon payments of R50 000 (5% of the face value of R1 000 000) for 10 years
After 10 years when the bond matures, the issuer will pay you back the face value of R1 000 000
Therefore you receive R50 000 a year for 10 years as the income component, and then make a capital gain of R20 000 (R1 000 000 – R980 000) at the end of 10 years. The price of the bond can change during the lifetime of the bond, but the face value and coupon payments will remain the same.
The price of the bond may change due to changing interest rates in the country of issue, and can often be more than the face value of the bond. Those of you on the ball may be wondering what the return effect will be if the the bond price is more than face value, in which case it will result in a capital loss at the maturity of the bond, since you are receiving less money at maturity than the price you paid to purchase the bond.
This situation happens all the time and if the coupon payments are high enough it can nullify the capital loss component and the investor can still walk away with a positive return at the end of the day.
The above scenario was just meant as an overview for how a bond works, and generally only sophisticated investors (such as asset managers on behalf of clients) or investors with significant capital will invest directly in bonds. For the majority of people (myself included), bond exposure can be achieved through unit trusts or ETFs.
The important thing to remember is that fixed income provides relatively predictable cash flows compared to equity as well as capital gain component. Although the potential of this gain is generally not as significant as equity.
Direct real-estate investment is pretty straight forward. Rent is generally the income component received from the tenants. While the capital gain is made by selling the property at a higher price to which it was bought.
Indirect real-estate through investing in a REIT (real-estate investment trust) takes the form of an equity type of return. This is because the pooled rent the REIT makes from its property portfolio is distributed as a dividend to the shareholders of the REIT. Since a REIT is traded on a stock exchange the capital gain or loss is the difference between the price at which the REIT share is bought and sold.
REIT’s dividend distributions are more stable and predictable than equity since the rent they receive is generally consistent and predictable (especially with a large property portfolio). Interest rates often significantly affect the share price of a REIT as well. With this in mind it can be seen that REITs are more characteristic of a fixed income asset than equity. However it still has some equity characteristics in the sense that a REIT is, after all, a company.
Since a commodity is a physical asset it usually does not provide an income component. There are instances where you could create an income stream from a commodity but this is a complex process and usually reserved for sophisticated investors such as asset managers. Thus, the total return of investing in a commodity is usually always the capital gain or loss.
Determining Which Returns to Target
You have probably heard the phrase “higher risk means higher reward”, or something of the sort. In general, the income component of total return has a lower level of risk associated with it. This is because assets that provide income predominantly (such as fixed income, and to a lessor degree real-estate) often have less uncertainty with regards to the amount and timing of the income payments to the investor.
The reason for this is because the issuer of the investment (the seller) usually has a plan in place to make these payments. This increased certainty (lower risk) generally comes with a relatively lower return. This is logical since the lower the income payment to the investor, the more certain the investor can be they will receive this payment, since it probably won’t “break the bank” of the entity that makes the payments.
The capital gain component on the other hand has much lower certainty. After all, if you buy an asset today, you cannot know with certainty what the price of this asset will be next year. If such was the case, we would all be wealthy. Prices of assets change all the time, some even change from second to second.
That being said, the capital gain component often provides significantly higher returns than that of the income component, the problem in achieving this return comes in with investor behavior.
Equity is a great example of this. An investor may hold shares in a specific company that provides no income component (no dividends) for years and years. Only to sell those shares at a significantly higher price than which they were bought and often dwarfs the return of even the best fixed income investment available at the time.
So it begs the question. Which return do you target and why?
Well, this depends on a number of factors and there is no hard and fast rule as to which component to target. Personal beliefs, unique circumstances, stage of life, level of financial wealth and financial sophistication are but a few issues that may help determine which component to target.
In general though, the more certain you need to be about your return the more conservative you should be and the more you should target the income component. On the other hand, if you are not too worried about the short-term return of an investment, and do not need income urgently, then targeting the capital gain component may be prudent.
In essence the take-away is this:
If you (among other things):
Need to be more certain about your return
Have a definitive investment horizon of less than 2 years
Require regular income payments
Then targeting the income component may be prudent.
If you (among other things):
Can stomach uncertainty
Have a definitive investment horizon of more than 5 years
Do not need this money to support you currently
Then targeting the capital gain component may be prudent.
Next: Risk Considerations