The Tortoise andthe hare ISSUE 56 | November 2015

Yield vs. Total Return

Many investors, including retirees, rely on their

investment portfolio to fund their cash needs.

This need can be approached in one of two ways.

The first approach looks primarily to interest

and/or dividends from securities to fund cash

flow needs. The amount of dividend and interest

income generated by a portfolio is largely

determined by dividend policies of the firms and

prevailing market interest ratestwo variables

outside an investors control. Investors may also

allow their preference for yield to influence their

asset allocation by focusing on securities with

higher yields.

An alternative approach, focused on total

return, involves selling assets in the portfolio to

create cash flow. This method reflects the idea

that, from an investment standpoint, it makes

little difference whether returns are delivered

as dividends or capital gains. Selling assets also

allows greater control over the amount of cash

flow generated.

Traditionally, income-oriented investors have

chosen the first approach, resulting in a bias

for securities that pay interest and dividends.

However, investors should carefully consider

the investment tradeoffs in pursuing an income-

based strategy, as their income bias may affect

diversification and expected returns.

Before pursuing a yield bias, investors should

understand the potential effect on portfolio

diversification and expected returns.

In this brief, we explore the yield vs. total return

approaches to generating income in a portfolio

and address misconceptions about the benefits

of emphasizing dividend and interest income at

the expense of other portfolio issues.

The traditional appeal of dividends stems from

a long-held belief that stocks paying high

dividends are less risky because they offer a

regular stream of payments to investors. But

dividend payments are not created out of thin air.

They flow from a companys earnings or assets,

which are reflected in the current stock price. As

illustrated in Exhibit 1, when a company pays a

dividend, its stock price is reduced by an amount

approximately equal to the dividend (Scenario

1). When accounting for this cash dividend, the

portfolio value may be unchanged.

Dividend Appeal

1

Yield vs. Total Return

Part of the conventional wisdom about dividends

is that a high dividend yield may help a retiree

avoid encroaching on capital to generate cash

flow. Yet, Exhibit 1 shows that a dividend does

encroach on capital unless it is reinvested rather

than spent. Although no stock may have been

liquidated, the economic impact is essentially the

same.

Another common misconception is that dividends

offer downside protection by mitigating the

impact of a falling stock price on the portfolio.

For example, a stock that yields a 5% dividend

can decline by up to 5% before the investor

experiences a negative total return. However,

since a dividend paid reduces the stock price by

the same amount, any additional non-dividend

related price decline would result in a negative

total return.

Exhibit 2 illustrates that a dividend-paying stock

may not offer special downside protection.

Consider a stock that loses 25% of its value before

the dividend payment. After the dividend payment,

the share price further drops by the amount of the

dividend, but the investor also has cash from the

dividend. Overall, the investor has still suffered a

25% loss.

Other Tradeoffs

A global portfolio of dividend-paying stocks

would have similar average returns to a

portfolio of non dividend-paying stocks.

However, a dividend-focused portfolio

would exclude 35%40% of stocks globally,

resulting in lower diversification. Also, the

number of US and international firms that

pay dividends is shrinkingfrom 71% of the

market in 1991 to 61% in 2012.

The proportion of dividend-paying firms

varies considerably across countries. For

example, 92% of Japanese stocks paid

dividends in 2012, compared to only 38%

of Australian stocks. Dividend payout levels

also have high cross-country variation. For

example, an average 31% of corporate

earnings were distributed in Switzerland vs.

73% in New Zealand.

Holding only dividend-paying stocks may

impact investors ability to pursue higher

expected returns. The research shows that

global portfolios holding only dividend-

paying stocks exclude about 47% of the

available small cap stock universe, which

historically has offered higher average

returns than large cap stocks.

Dividends are not certain or guaranteed.

Although dividends may be less volatile than

the capital gains component of stock returns,

the aggregate stream of dividend

2

Holding a portfolio that emphasizes dividend-

paying stocks may also force significant tradeoffs

related to diversification and expected returns

(Black, 2013) . The research concluded that:

Yield vs. Total Return

payments is subject to the same broad,

macroeconomic risks that affect capital gains. As

demonstrated in the 20082009 financial crisis,

companies have reduced dividends after large

market declines.

The alternative to meeting a cash flow need

through dividend and interest payments is to create

cash flow by selling securities in the portfolio. By

selling assets, investors have greater control over

the level and timing of cash flows. Investors can

also reduce their reliance on dividend yields and

market interest rates, both of which are variable

through time and outside their control.

Investors in taxable accounts should consider any

tax implications that may arise from differences in

capital gains and dividend tax rates . For example,

if capital gains are taxed at lower rates than

dividends, a stock sale may be more tax efficient.

Furthermore, the lower tax rate is only applied

to the portion of the cash flow that represents

the stocks capital gain, whereas the higher tax

rate for dividends is applied to the full amount

of the dividend. Tax treatment of dividends from

domestic companies vs. foreign companies may

also play a role in the outcome.

Exhibit 3 illustrates the impact of earning

dividends vs. selling assets to create cash flow

from a portfolio. In Scenario 1, the stocks price

per share is reduced by the dividend, whereas in

Scenario 2 the share price stays the same but the

number of shares is reduced. After the respective

dividends are received, the portfolio balance

sheets for Scenarios 1 and 2 have the same

value and asset composition. Thus, an investors

approach to generating cash flow may not affect

total portfolio value on a pre tax basis.

A final consideration in structuring portfolio

income is the implication for rebalancing.

Generating cash flow from securities sales may

create an opportunity to strategically rebalance by

selling assets that are overweighted relative

to the target allocation.

Investors must also consider their goals for

fixed income when determining an appropriate

asset allocation. Investors seeking yield in fixed

income may consider incorporating term or credit

premiums. However, market interest rates can be

volatile, so the cash flows generated by interest

income will vary over time. Investors seeking

greater control over their cash flows could also

consider selling assets rather than relying heavily

on interest income.

Total Return: Creating Cash Flow

Fixed Income as a cash source 3

Yield vs. Total Return

Conclusion

There may be greater control in generating cash flows by selling securities rather than relying on dividend

and interest income, although individual needs may vary. Firms payout policies evolve over time, as do

market interest rates. Rather than letting portfolio yields determine spending rates, investors can develop

a sustainable withdrawal strategy with their advisors.

1. Certain studies show the price drop on the ex-dividend date is, on average, lower than but close to the amount of the dividend

when controlling for market movement.

2. Black, Stanley. March 2013. Global Dividend-Paying Stocks: A Recent History. Dimensional Fund Advisors white paper.

3. As of this writing, tax rates for long-term capital gains and qualified dividends are the same in the US (15% or 20%, based on a

taxpayers income bracket). But tax rate differences have occurred in the past and may occur again in the future.

Risk Warnings

This issue brief is offered only for general informational purposes and does not constitute investment, tax, or legal advice and should not

be relied on as such. You should not act or rely on any information contained in this article without first seeking the advice of an advisor.

Portfolio investment values will fluctuate, and shares, when redeemed, may be worth more or less than original cost. Diversification neither

assures a profit nor guarantees against a loss in a declining market. Strategies may not be successful. Past performance is no guarantee of

future results. Small cap investments are subject to greater volatility than those in other asset categories. International investing involves

special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks.

All expressions of opinion are subject to change without notice and are not intended to be a guarantee of future events. This document is for information only and does not constitute a solicitation to buy or sell securities nor does it purport to be a complete description of our invest-ment policy, markets or any securities referred to in the material. Opinions expressed herein are not intended to be a forecast of future events or a guarantee of future results or investment advice and are subject to change without notice or based on market and other conditions. Any reference to model portfolios, which is used for internal purposes, is purely illustrative. The value of investments and the income from them may fluctuate and can fall as well as rise. Past performance is not a guarantee of future results. You may not recover what you invest.

Although information in this document has been obtained from sources believed to be reliable, MASECO LLP does not guarantee its accuracy or completeness and accepts no liability for any direct or consequential losses arising from its use. Throughout this publication where charts indicate that a third party (parties) is the source, please note that the source references the raw data received from such parties.

MASECOLLP and its affiliates do not provide tax or legal advice and levels and bases of taxation can change. To the extent that this material or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Any such taxpayer should seek advice based on the taxpayers particular circumstances from an independent tax advisor.

Neither asset allocation nor diversification assures a profit or protects against a loss in declining financial markets. Currency fluctuations may increase or decrease the returns of any investment.

Bonds are affected by a number of risks, including fluctuations in interest rates, credit risk and prepayment risk. In general, as prevailing interest rates rise, fixed income securities prices will fall. Bonds face credit risk if a decline in an issuers credit rating, or creditworthiness, causes a bonds price to decline. High yield bonds are subject to additional risks such as increased risk of default and greater volatility because of the lower credit quality of the issues.

Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio.

Finally, bonds can be subject to prepayment risk. When interest rates fall, an issuer may choose to borrow money at a lower interest rate, while paying off its previously issued bonds. As a consequence, underlying bonds will lose the interest payments from the investment and will be forced to reinvest in a market where prevailing interest rates are lower than when the initial investment was made.

Alternative investments referenced in this report are speculative and entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns on transferring interests in the fund, potential lack of diversification, absence of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds and advisor risk.

Investing in commodities entails significant risks. Commodity prices may be affected by a variety of factors at any time, including but not limited to (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary

distortions or other disruptions due to various factors, including lack of li-quidity, participation of speculators and government intervention.

The prices of real assets (for example, precious metals) tend to fluctuate widely and unpredictably, and have historically experienced periods of flat or declining prices. Prices are affected by global supply and demand, inves-tors expectations with respect to the rate of inflation, currency exchange rates, interest rates, investment and trading activities of hedge funds and commodity funds, and global or regional political, economic or financial events and situations.

REITs investing risks are similar to those associated with direct investments in real estate: lack of liquidity, limited diversification and sensitivity to economic factors such as interest rate changes and market recessions.

The indices are unmanaged, are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include expenses, fees or sales charges, which would lower performance.

International investing entails greater risk, as well as greater potential rewards compared to investing in your local stock market. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economics.

Investing in smaller companies involves risks not associated with more established companies, such as business risk, significant stock price fluctuations and illiquidity.

Interest on municipal bonds is generally exempt from US federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax exemption applies if securities are issued within ones state of residence; if applicable, local exemption applies for issues within ones city of residence.

The initial interest rate on an inflation-linked security may be lower than that of a fixed rate security of the same maturity because investors expect to receive additional income due to future increases in CPI. However, there can be no assurance that these increases in CPI will occur.

Changes in exchange rates may have an adverse effect on the value, price or income of foreign currency denominated securities.

Investments or investment services referred to may not be suitable for all recipients.

In the UK, certain services are available through MASECO LLP (trading as MASECO Private Wealth and MASECO Institutional) which is registered in England and Wales, number OC337650, with registered offices at Burleigh House, 357 Strand, London, WC2R 0HS, telephone +44 (0)20 7043 0455, email enquiries@masecopw.com. MASECO LLP is authorised and regulated by the Financial Conduct Authority for the conduct of investment business in the UK. The Financial Conduct Authority does not regulate tax advice or offshore investments. Messages and telephone calls to and from MASECO Private Wealth may be monitored to ensure compliance with internal policies and to protect our business.

MASECO LLP is a FINRA/SEC Registered Investment Advisor in the United States of America.

US Treasury Department Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you any US federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.