By Michelle McGrade, chief investment officer of TD Direct Investing

It is important for all investors, whether they are seeking capital growth or looking to draw income from their portfolio, to understand and consider total returns.

If you’re looking at this and you’re an investor gunning for growth stocks, then you should definitely keep reading. Equally, all of you income hunters should take note. Building your portfolio with total return in mind gives you the best of both worlds, so why focus on just one? Here I take a closer look at how total return works and how it can benefit you. Let’s start with how they’re made up.

Total Return = Capital Gain + Investment Income

Investments such as equities, bonds and funds provide returns which consist of two key components. The first is the capital value. The capital value is one that increases or decreases depending on the price of the asset. The second part of the return is income.

Income can come in various forms – equities pay out dividends and bonds make interest payments known as coupons. Many funds also deliver income regularly because they distribute the dividends and coupons from their underlying assets.

The total amount of value that investors earn from their investments, in other words capital plus income, is called total return.

Why are total returns important?

  • Can better meet investment needs for certain investors
  • Improve portfolio tax efficiency if invested in an ISA or SIPP
  • Can enhance returns across different market environments

Income has always accounted for a meaningful portion of total return. This has particularly been the case during lower-return environments as investors turn to dividends or coupons to generate income.

It is important to note that there are different tax treatments for capital gains and income. Capital gains are subject to capital gains tax (CGT) via the investor’s annual tax return (any unused allowance can also be rolled over), while income is taxed at the investor’s marginal rate.

This, though, is where investing via an ISA can come into its own, as this way you are not liable for any further tax on either capital or income from your investments, within the annual subscription limits. In your SIPP (Self Invested Personal Pension) both returns are also tax-efficient. If you have a drawdown portfolio, capital and income can accumulate tax-efficiently but any drawings out of the portfolio are treated as such for tax purposes, so may alter the way you think about drawing from this portfolio.

The power of compounding returns

Historically, dividends have made up a significant portion of the total return from equities. If higher returns are your goal, an effective way of achieving this is to reinvest the income from dividends back into the market and make use of the power of compounding.

You can see from the chart below the difference between the returns you would have gotten from a £10,000 investment in the FTSE All Share index over the last 20 years without dividend reinvestment (£19,235), illustrated in the chart as price return. By comparison, reinvesting the dividends would have delivered a much higher return of £36,769.

power reinvesting dividends

Past performance is not a reliable indicator of future returns.

Source: Morningstar Direct as at 31st December 2016 of compounding.

A capital growth fund versus an income fund

When considering the difference between investing for capital growth or income, you could consider the BlackRock UK and Schroder Income funds. BlackRock UK has a long-term capital growth focus. The Schroder fund, meanwhile, aims to deliver a good level of income as part of a total return strategy.

A capital growth fund versus an income fund

Past performance is not a reliable indicator of future returns.

Source: Bloomberg      

Similarly, from a more global perspective Baillie Gifford International seeks out companies which are able to generate above average earnings growth, while Artemis Global Income aim to achieve a combination of capital growth and rising income via a global equity portfolio.

combination of capital growth and rising income via a global equity portfolio

Past performance is not a reliable indicator of future returns.

Source: Bloomberg   

As always, a portfolio diversified across a range of different geographies and styles will give you the best possible chance of reducing risk and generating a return which fits with your long-term investment goals. When you think of return, remember that it comes from two sources: capital value, and income; and these can have different return profiles during different market conditions.

If you want to maximise your return the clever thing is often to reinvest the income. But when looking at your next investment, make sure you consider the total return.

For more information on total returns, take a look at our Spring Investment Outlook.

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