Total return portfolio

What Is a Total Return Portfolio?

A total return portfolio is an investment strategy centered on maximizing an investor's overall return from all sources: capital appreciation, dividends, and interest payments. Unlike traditional approaches that might prioritize only income generation (e.g., dividends from stocks or interest from bonds) or solely capital appreciation, a total return portfolio considers these components as equally valuable contributions to the portfolio's growth. This approach falls under the broader umbrella of portfolio theory, emphasizing a holistic view of investment returns. The primary objective of a total return portfolio is to achieve the highest possible return over a specified period, taking into account the investor's risk tolerance and financial goals.

History and Origin

The concept of total return investing gained significant traction, particularly within institutional portfolio management in the latter half of the 20th century. Historically, many institutional endowments and foundations operated under a "spending rule" that limited distributions to only the income generated by the portfolio, such as dividend income and interest income. This often led to portfolios heavily skewed towards high-yielding, but potentially less growth-oriented, assets.

A pivotal shift occurred with the work of investment managers like David Swensen, who, as the Chief Investment Officer of Yale University's endowment, popularized a total return approach. Swensen's strategy, often referred to as the "Yale Model," emphasized broad asset allocation across diverse and often illiquid asset classes, focusing on the combined return from income and capital gains rather than just current income¹⁹, ²⁰. His pioneering efforts significantly influenced how large endowments and foundations manage their investments, moving away from a strict income-only focus to a more flexible and potentially higher-returning total return framework. David Swensen, who revolutionized endowment investing, passed away in May 2021¹⁸.

Key Takeaways

• A total return portfolio aims to maximize the combined gains from both investment income (dividends, interest) and capital appreciation (price increases).
• It provides greater flexibility in asset allocation, allowing investors to select investments based on their overall return potential, not just their yield.
• This strategy often involves reinvesting all income and capital gains back into the portfolio to benefit from compounding over time.
• The total return approach can be particularly beneficial for long-term investors, such as those engaged in retirement planning, as it prioritizes long-term wealth accumulation.
• It contrasts with income-focused strategies, which solely emphasize generating a steady stream of cash flow from the portfolio's current income.

Formula and Calculation

The total return of an investment or a portfolio is calculated by summing the capital appreciation and any income generated, expressed as a percentage of the initial investment. This calculation assumes that all income distributions are reinvested.

The formula for total return is:

Where:

• Ending Value = The market value of the investment at the end of the period.
• Beginning Value = The market value of the investment at the start of the period.
• Income = All dividends, interest, and other distributions received during the period, assuming they are reinvested.

For example, if an investor buys a stock for $100, it grows to $105, and pays a $2 dividend income over a year, the total return would be:

Morningstar's calculation of total return determines it by taking the change in net asset value, reinvesting all income and capital gains distributions, and dividing by the starting net asset value¹⁷.

Interpreting the Total Return Portfolio

Interpreting a total return portfolio involves assessing its performance based on the combined effect of capital gains and income, rather than isolating one component. A higher total return percentage indicates a more effective overall growth of the portfolio. Investors applying this strategy understand that withdrawals for living expenses or other needs can come from either income distributions or by selling appreciated assets. This flexibility is a core tenet of the total return approach.

For instance, if a portfolio generates 2% in dividend income and 5% in capital appreciation for a total return of 7%, an investor needing 4% for expenses could choose to take all the income and sell a small portion of appreciated assets. This approach allows the investor to adapt to market conditions, avoiding the need to "reach for yield" by investing solely in high-income assets, which might carry undue risk or limit diversification. It also implies that investors view all dollars returned to the portfolio as fungible, regardless of their source¹⁶.

Hypothetical Example

Consider an investor, Sarah, who begins the year with a total return portfolio valued at $100,000. Her portfolio is diversified across various asset classes, including stocks that may offer growth stocks potential and bonds providing interest.

Throughout the year:

• Her stock holdings increase in value by $7,000.
• She receives $3,000 in dividend income and interest income from her investments, which she promptly reinvests into the portfolio.

At the end of the year:

• The market value of her portfolio is now $107,000 (initial $100,000 + $7,000 capital appreciation).
• The reinvested income of $3,000 has further increased her overall portfolio value to $110,000.

Using the total return formula:

Sarah's total return for the year is 10%. This hypothetical example demonstrates how both capital appreciation and reinvested income contribute to the overall growth of a total return portfolio.

Practical Applications

Total return portfolios are widely applied in various financial contexts, particularly in strategic asset allocation and retirement planning. For individuals planning for retirement, a total return strategy allows them to build a broadly diversified portfolio that includes different types of bonds and stocks, exposed to various industries, geographies, and currencies¹⁵. Rather than relying solely on current income to fund living expenses, retirees can draw from both capital gains and income, offering greater flexibility and potentially a larger pool of funds to meet their needs. This approach is often recommended by financial professionals for its emphasis on long-term growth and its ability to adapt to varying market conditions¹⁴.

For instance, institutional investors like university endowments and foundations extensively use the total return approach to ensure the long-term sustainability of their funds while still providing annual distributions for operational needs. The Yale University endowment, under its late Chief Investment Officer David Swensen, famously pioneered a total return model that diversified significantly into alternative investments alongside traditional stocks and bonds¹², ¹³. This strategy helped the endowment achieve substantial long-term returns, allowing Yale to increase spending from the endowment to support its budget¹⁰, ¹¹. A well-structured total return portfolio can help mitigate the impact of market volatility by allowing withdrawals from appreciated assets during periods of low income yields.

Limitations and Criticisms

While beneficial, total return portfolios also have limitations and criticisms. One primary concern is the potential for behavioral challenges, especially for retirees. Relying on selling appreciated assets for income can be psychologically difficult, as it might feel like "eating into principal," even if the portfolio is growing overall⁸, ⁹. This can lead some investors to underspend or become overly conservative, potentially missing out on long-term growth.

Another criticism relates to tax efficiency. While total return investing emphasizes maximizing overall gains, it doesn't inherently optimize for taxes. Capital gains, particularly short-term gains, may be taxed at higher rates than qualified dividend income in some jurisdictions, and the timing of sales to generate cash flow can lead to undesirable tax events. Investors must consider the potential impact of taxes on their overall returns, as distributions can be taxed, and a total return calculation typically doesn't account for these costs⁶, ⁷. The Internal Revenue Service (IRS) provides guidance on various tax implications for investments⁴, ⁵.

Furthermore, in periods of prolonged market downturns, a total return strategy might necessitate selling assets at a loss to generate needed cash, exacerbating portfolio depletion. This is known as sequence of returns risk. While the strategy offers flexibility, it requires disciplined portfolio management and a clear understanding of one's withdrawal strategy to avoid liquidating too much capital during adverse market conditions², ³. Some critics argue that an overreliance on capital gains, particularly in low-interest-rate environments, could force investors to take on excessive risk tolerance to meet return targets¹.

Total Return Portfolio vs. Income Investing

The fundamental distinction between a total return portfolio and income investing lies in their approach to generating returns and managing withdrawals.

While income investing seeks to avoid touching the "principal" by living off the income, a total return portfolio views all parts of the portfolio as fungible for meeting withdrawal needs. This philosophical difference allows the total return approach to seek a wider range of investment opportunities and potentially achieve greater overall wealth accumulation over the long term.

FAQs

What is the main goal of a total return portfolio?

The main goal is to maximize the overall investment return, combining both capital appreciation (growth in asset value) and income (dividends and interest) into a single, comprehensive measure. This contrasts with focusing solely on one component.

How does a total return portfolio generate money?

A total return portfolio generates money through two primary avenues: the increase in the market value of its underlying assets (capital gains) and the income produced by those assets, such as dividend income from stocks or interest income from bonds. All these sources contribute to the "total return."

Is a total return portfolio suitable for retirement?

Yes, a total return portfolio is often considered highly suitable for retirement planning. It offers flexibility by allowing retirees to draw income from a combination of capital gains (by selling appreciated assets) and investment income, rather than being restricted to just the income generated. This can lead to a more diversified and potentially higher-performing portfolio over the long term.

How is a total return portfolio different from an income-only portfolio?

The key difference is how withdrawals are managed and what investments are prioritized. An income-only portfolio focuses on assets that generate substantial current income to meet spending needs, aiming to preserve the principal. A total return portfolio, conversely, considers capital gains and income interchangeably for withdrawals, allowing for broader asset allocation and a focus on maximizing overall growth.

What are the potential drawbacks of a total return portfolio?

Potential drawbacks include the psychological difficulty for some investors of selling assets (eating into principal), the need for careful tax planning to manage capital gains taxes, and the risk of depleting capital during prolonged market downturns if withdrawal rates are too high. It requires a disciplined portfolio management approach.