Why you should blend income and growth

From Shares:

ncome and growth are often seen as two mutually exclusive investment styles, but combining the two can sometimes yield better results.

This can be the case whether you’re a young investor seeking capital growth or a retiree needing a regular income.

Why should I blend styles?

A key reason for blending the two styles – a practice known as total return – is that it can result in a more diversified and balanced portfolio.

You’ll have exposure to a greater range of business types and sectors, which should perform differently at different times of the economic cycle.

In growth phases your portfolio might not rise as much had you invested entirely in a growth strategy. But when times are tough the typically more defensive areas used by equity income strategies should protect you from some of the falls.

This is illustrated by comparing the performance of the average growth fund in the UK (the IA UK All Companies sector) with the average income fund (the IA UK Equity Income sector) over the past 20 years.

According to AJ Bell Youinvest, an initial investment of £10,000 would have risen to £29,708 in a growth fund and £25,523 in an income fund. On a total return basis (including reinvested income) the figures would be £33,028 and £39,139 respectively.

Why is it risky to focus on income?

One risk of focusing on income is it pushes you towards a small number of high-yielding companies. Some of these companies may have temporarily elevated dividends because they have encountered short-term problems or poor market conditions.

If a company trades at 50p and pays an annual dividend of 2.5p, its yield is 5%. If the company gets into difficulty and the share price halves to 25p, the dividend yield will be 10%. This looks attractive, but it’s highly likely that whatever caused the share price to crash will also result in the dividend being cut.

Laura Foll, co-manager of Henderson UK Equity Income and Growth (GB0007494221), says emphasising income can put a focus on companies which are towards the mature end of their lifecycle. They offer a high dividend payout ratio because opportunities for investing in growth may be limited.

‘If the focus is solely on delivering a set level of income for clients without focusing on capital, the risk is that over time this draws you to companies and industries that, while they look as if they are standing still, are in reality shrinking,’ says Foll.

‘Ultimately it is only by growing the capital base that income can be grown sustainably over time. This requires a focus on companies that have the capability to grow sales and earnings, and therefore dividends.’

What’s wrong with concentrating on growth?

Focusing on growth creates a different set of risks. Foll says the need to generate cash (in order to pay a dividend) is a good discipline for companies. The directors know they will need to answer to shareholders if they have chosen to bypass the dividend in favour of an acquisition or internal investment.

‘This forces them to look very closely at the merits of these investments relative to returning cash to shareholders. Studies also show that over the long term, dividends are a substantial portion of the returns from equities,’ Foll adds.

What if I’m old and don’t need growth?

Even if you’re old and think growth is irrelevant, it’s still a good idea to diversify your portfolio so you’re not over-reliant on a narrow group of industries.

‘Some people may think that by holding a number of income strategies they have this diversification, but a look under the bonnet very often finds they each have exposure to similar companies which are exposed to the same economic risks,’ says Ryan Hughes, head of fund selection at AJ Bell Youinvest.

Longevity is increasing which means your money needs to last a very long time in retirement – possibly 30 years. Having an element of growth in your portfolio increases the chances of sustaining it over a long period, particularly when you’re withdrawing money.

Another issue is that it might not be possible to achieve your desired level of income from a pure income strategy. You may need to supplement it with capital withdrawals.

Jon Wingent, head of portfolio specialists at Lloyds Wealth Investment Office, explains: ‘Think of an investor who needs £5,000 a year from an investment capital of £100,000. That equates to 5% a year from the outset and that would be difficult to achieve purely from income in the current climate.

‘A total return solution returning 6-8% a year, with only 3% coming from income, allows the shortfall to be made up from growth, plus this does not erode the capital.’

Funds that combine the styles

There are lots of funds that blend income and growth. They are typically multi-asset funds as oppose to those that follow a single strategy.

Eugene Philalithis, portfolio manager of Fidelity Multi Asset Income & Growth (GB00BFPC0D88), says these funds allow investors to generate a steady income while delivering some capital growth to protect against rising inflation.

They typically hold equities and higher-risk fixed income securities like high yield bonds.

There are also some equity income funds which seek to deliver a combination of both income and growth.

Hughes likes River & Mercantile UK Equity Income (GB00B3KQG447), which offers a yield greater than the FTSE All Share but also focuses on delivering capital growth over time.

There is also TB Saracen Global Income & Growth (GB00B5B35X02), which focuses on companies that have revenue, profit and the ability to grow their dividends, rather than companies that offer the highest yield.