Total Return: Smoke and Mirrors?

Just what is this “total return” hoop that investment managers are required to jump through? Why is it mostly just smoke and mirrors? Here’s the formula:

  • Total Income + (or -) Change in Market Value – Expenses = Total Return — the ultimate test for any investment portfolio.

Applied to income purpose portfolios, it is really close to nonsense, and confusing to most investors.

Remember John Q. Retiree? He was the guy with his chest all puffed up one year, bragging about the 12% “Total Return” on his bond portfolio. Secretly, he wondered about having only 3% in actual spending money.

A year or so later, he’s scratching his head wondering how he’s going to make ends meet with a total return that’s approaching zero. Do you think he realizes that his spending money may be higher?

What’s wrong with this thinking? How will the media compare mutual fund managers without it?

Wall Street doesn’t much care. They set the rules and define the performance rulers, and they say that income and equity investment performance can be measured with the same tools. They can’t, because their investment purposes are different.

If you want to use a ruler that applies equally well to both classes of security, just change one piece of the formula and give the new math a name that focuses on the actual purpose of income investing — the spending money.

We found this old way of looking at things within “The Working Capital Model”; the new and improved formulae are:

  • For Fixed Income Securities: Total Cash Income + Net Realized Capital Gains – Expenses = Total Spending Money!
  • For Equity Securities: Total Cash Income + Net Realized Capital Gains – Expenses = Total Spending Money!

Yes, they are the same, and divided by the amount invested, they produce a Total Realized Return number. The difference is what the investor elects to do with the spending money.

So if John Q had taken profits in year one, he could have spent more, or added to his income production. You just can’t spend (or reinvest) “Total Return”.

We’ve taken those troublesome paper profits and losses out of the equation entirely. “Unrealized” is “un-relevant” in a properly diversified portfolio comprised only of investment grade, income producing securities.

Most of you know of Bill Gross, the Fixed Income equivalent of Warren Buffett. He manages a humungous bond mutual fund, but how does he invest his own money?

According to a NYT Money and Business article by Jonathan Fuerbringer (January 11, 2004), he’s “out” of his  own Total Return fund and “in” Closed End Muni Funds paying 7.0% tax free. (Must have read “The Brainwashing of the American Investor”.)

Fuerbringer doesn’t mention the taxable variety of CEF, then yielding roughly 9%, but they certainly demand a presence in the income security bucket of tax-qualified portfolios like 401ks. Sorry, can’t do that now. The omniscient DOL says the net/net income isn’t nearly as important as the Expense Ratio….

Similarly, Mr. Gross advises against the use of the non investment grade securities (junk bonds, etc.) that many fund managers  sneak into their portfolios.

But true to form, Mr. Gross is as “Total Return” Brainwashed as the rest of the Wall Street institutional community, as he gives lip service validity to speculations in commodity futures, foreign currencies, derivatives, and TIPS.

Inflation impacts buying  power, and the only way to beat it is with higher safe income. If TIPS rise to 5%, REITS will yield 12%, and preferred stocks 9%, etc. No interest rate sensitive security is an Island!

As long as financial intellectuals remain mesmerized with total return numbers, investors will be the losers.

  • Total Return goes down when yields on individual securities go up, and vice versa. This is a good thing.
  • Total Return analysis is used to engineer market timing decisions between fixed income and equity investments, based on statements such as: “The total return on equities is likely to be greater than that on income securities during this period of rising interest rates.”

Investors have to commit to the premise that the primary purpose of income securities is income production… this requires a focus on spending money.

If these three sentences don’t make complete sense to you, you need to learn more about income purpose investing:

  • Higher interest rates are the income investor’s best friend. They produce higher levels of spending money.
  • Lower interest rates are the income investor’s best friend. They provide the opportunity to add realized capital gains to total spending money and to total working capital.
  • Changes in the market value of investment grade income securities are totally and completely irrelevant, 99% of the time.

Real Estate Investment Trusts (REITs)

Many investors whose incomes are suffering from low interest rates have begun to seek investment alternatives to help supplement those incomes. One possibility often suggested is a real estate investment trust (REIT). REITs are a way to invest in commercial real estate without the responsibility of managing a property yourself, and with a much smaller investment than might otherwise be needed. However, REITs aren’t suitable for every investor, and there are many factors to consider carefully before you buy.

Types of REITs
REITs can be classified based on their holdings. Equity REITs typically buy, sell, renovate, manage, and maintain real estate properties, and their return comes primarily from tenants’ rents. Equity REITs may specialize in a specific type of property, such as warehouses, office or apartment buildings, health-care facilities, or shopping centers, or diversify across a variety of holdings. Mortgage REITs, which are less common than equity REITs, invest in mortgages and mortgage-backed securities or lend money to real estate owners or developers. Their income is derived largely from interest on those loans or securities plus any change in the value of those securities. Hybrid REITs employ both strategies.

REITs can be publicly traded on an exchange like stocks, or publicly registered but not publicly traded. They also can be private placements, which are not subject to the same disclosure or SEC registration requirements as either exchange-traded or nontraded REITs, and are only available to high-net-worth individuals. However, remember that even registration with the Securities and Exchange Commission doesn’t necessarily mean that a REIT will be a good investment or appropriate for you.

Why invest in a REIT?
Diversification: Because the performance of REITs may not be highly correlated with the performance of stocks or bonds, they may offer another way to broaden your investment portfolio. Though diversification alone can’t guarantee a profit or protect against the possibility of loss, it can potentially help you manage your portfolio’s overall level of risk.

Income: As long as it pays out at least 90% of its net income, a REIT can deduct dividends paid to shareholders from its corporate taxable income. That lack of a tax burden can increase the amount available to distribute to shareholders, potentially making a REIT a source of ongoing income.

Potential tax advantages: The legal structure of some REITs allows them to use depreciation and deductions to offset or eliminate current tax liability on their cash distributions, essentially creating a tax-deferred income stream for shareholders. The tax code treats those distributions as a return of capital rather than corporate dividends, and they are used to adjust the shareholder’s cost basis when the shares are sold.

Potential for keeping pace with inflation: Though current inflation is low, some experts worry that the Federal Reserve’s efforts to stimulate the economy could eventually change that. Because landlords may be able to raise rents to keep pace with rising costs, real estate has traditionally been considered to be more inflation-resistant than bonds.

Factors to be aware of
Potential liquidity issues: In the past, individual rather than institutional investors have been the primary market for some types of REITs. Because institutions represent such a large percentage of the investing universe, that could potentially affect your ability to sell your shares at the price you expect. And be aware that non-exchange-traded and private-placement REITs are often extremely illiquid (see sidebar).

Valuations: Investors who have sought out REIT dividends as an alternative to the low interest being paid by U.S. Treasury bonds have helped drive up prices on many REITs in recent months, potentially increasing the danger that you could pay too much for shares. Before investing in a REIT, make sure you’ve carefully assessed its potential for further price appreciation along with other factors such as the stability of the rents on which a REIT’s dividends are based. You also should compare the share price to the actual market value of the underlying properties minus any outstanding debt, though this can be extremely difficult in the case of a nontraded REIT or private placement. Remember that REIT securities’ value can be affected by declines in rental income, changes in interest rates, property management, environmental issues, uninsured damage, competitive factors, or changes in real estate laws.

Potential tax complexity: Even though some REITs may provide a current tax benefit, they may require more attention at tax time. You’ll also need to consider the type of account in which you plan to hold a REIT. The potential tax benefits mentioned above for certain REITs can be negated if they’re held in a tax-advantaged retirement account.