I managed to catch a glimpse of a work conversation between a client adviser and our portfolio manager. The client adviser was seeking out our portfolio manager’s view about having more diversity in funds with natural distribution that we are confident to offer to clients.
I shall keep most of the discussion private but then again, I also didn’t catch much of the conversation except when our client adviser later explain his reasoning to have more diversity, especially in funds with natural distribution.
I think readers here would know my position regarding funds that naturally distribute payouts versus those that are only accumulating. You can check out my post on the 5.2% Allianz Global High Payout, the high income growth IJS, high income growth IDP6, the high income 6.6% yielding SEDY.
Naturally income paying products, beyond unit trusts have the following characteristics:
- The natural distribution from most products is not as consistent in a way you imagine mentally.
- They also don’t adjust the natural income paid out with inflation.
- God knows if the natural income keep up with inflation. Most of the natural income cannot be consistent in the first place.
- It is not in the interest of the manager, or the product provider to give you that consistent inflation adjusted income because the obligation is too much for them to handle.
- Many just don’t want to spend the capital and therefore have an affinity towards these natural income distributing products. They think that if you sell the units to get cash flow, the fund doesn’t last. But they would frequently mentally check off that if they only take the natural income distribution, they have consistent income. Wrong. By #1, your income is not as consistent. It is your mind wanting the income to be consistent but rarely are they like this.
- The way to solve all of the short coming of natural income paying products is to have enough income, such that if the income decreases because either you misjudge, your mental model is wrong, or you are unlucky with your market returns, you can still have the income to be consistent. This is essentially a Withdrawal Rate which the Safe Withdrawal Rate (SWR) seeks to figure out. But just so many cannot see what they are trying to do is similar to the SWR method.
Years of thinking about income led me to that conclusion and the more I profile these income products, the more it falls inline with this view. The few articles before that are examples of that.
I am not allergic to funds with natural income distributions and I think if just getting income delivered to your savings account instead of you having to sell funds (which to me is the same thing) makes you feel more safe and peaceful, then no harm in that.
But you cannot just think about the natural income payout yield at this very moment only!
There has to be some structural sensibilities that are wrapped around the products. The products do not give you an income stream that fits what you need in a way that will feel safe.
You or someone have to structure that safety, consistency and growth.
Why I like the Safe Withdrawal Rate framework is because it is such an easy to implement framework to structure that.
But I am not going to discuss that today.
You Need to Think About what are the Critical Characteristics Will Make Your Income Stream Work
The client adviser shared something about our existing natural income solution offering that made me consider more.
Not because it was a tough question that I need further thoughts but that more have to be able to distill what they feel comfortable, uncomfortable, like or dislike to more higher level characteristics of their income strategy.
If you are uncomfortable with something, most likely you will feel the natural income system will be glitchy.
In income products glitchy things may show up only later.
In my mind, what he questions is about the sources of income within a fund.
I like to talk about that because it pisses me enough especially when I have people around me that just doesn’t see this easily.
An Income Stream that You Want to be Passive and Perpetual Need Enough Diversified Sources of Performance.
If you want an income stream to last long, sometimes well beyond your lifetime, the critical characteristics is that it comes from diversified sources of performance.
It is not diversified sources of income. That one is a given.
You think about it, be it fixed income or equity in different funds, they distill down to like 400, or 3000 securities.
Do you tell me that each of them don’t distribute coupons or dividends? Perhaps some don’t or give little but they all do.
So there will be a diversity of income within even accumulating class of funds, much less distributing class of funds.
But income can only be sustain by the earnings/cash flow growth or it’s consistency over time. If you want the income to be perpetual, and you are concentrated in one company say DBS then DBS has to have income consistency and growth over time.
Then you got to ask yourself: how long have DBS give this current payout? How was its payout ratio like 15 years ago? Is it as as high as the current 70-75%? I can tell you not always. The payout ratio fluctuates.
But also, how old is DBS and if you had invest in DBS in the 1980s would you have a similar income experience?
If you are a systems person you would not feel comfortable because even companies that are listed for a long time like Coca Cola, General Electric when through periods of stress when they would potentially think of cutting their natural distribution, which is their dividends.
If you are looking at it from your systems engineering perspective, you would be able to see that if you want the income to last a long time (many want this income stream to pass to their next generation so that they can enjoy the income), what is the key criteria to fulfill here?
You need some diversity in sources of performance AND you need a system where the sources of performance can rejuvenate.
How to achieve this performance rejuvenation?
You need the income strategy to be able to reconstitute systematically.
Almost all the funds in my Daedalus Income portfolio have this systematic reconstitution periodically.
That is why my income strategy can be passive.
What many didn’t realize is that they are doing this reconstitution themselves and they became mentally lazy and assume they would choose good stocks that last a long time.
This chart shows the average company lifespan of the companies in S&P 500 from 1965 to now. That is coincidentally from Singapore’s independence. You can see the age is becoming lower and lower.
If you are designing a system, and you see this data, how would this influence your design?
The Emerging Market Case Study: Why You Need Diversity in Sources of Performance in Your Income Strategy
I like to bring up the emerging market example because away from the United States, it is neutral ground.
If you want to plan an income strategy that works, it should be independent of region and much base on characteristics.
If I force you to only use non-US equities and fixed income, can you design an income strategy around that? You should be able to and if so how would you think round it.
I would always remember one community member telling me: Kyith when it comes to emerging markets we have to be selective because not all countries will perform well.
Without a financial planning context, factually different countries, much less only emerging markets, will perform better than others over time.
But if we consider this in a portfolio, especially one that you want to last beyond you, can you afford to choose only China?
Or India?
In the time that person made the comment, I think China and India were the dominant countries in Emerging Markets.
It wasn’t during the time like 20 years ago in 2006.
During that time emerging market was damn damn damn hot.
It was the BRICS: Brazil, Russia, India and China.
Where is Brazil and Russia? They became less relevant and did not become relevant. Simple as.
But let’s look at the MSCI Emerging Markets IMI index or the EIMI ETF composition today:
Holy shit. Taiwan and South Korea leads.
Now I wonder if that community member then expect this kind of stuff.
Lets do a 20 year recap of what was roughly the emerging market shift:
- From Brazil, Russia, India and China
- to India and China
- to China
- to India
- to Taiwan and South Korea
That is in 20 years only.
How would it be like Kyith in next 60 years during my retirement.
If you see this you know Kyith also don’t know!
Those people who have strong views about India and China also has valid points but yet you see how it turned out today.
For context let us share how the EIMI look like 1 month ago:
South Korea basically leap frogged China in 1 month.
And this is in December 2023:
And this is in October 2020:
You touch your heart and wonder did you truly expect this to happen.
The Better Something Perform, Other Discomfort Starts Coming Out.
When the drivers of performance is so concentrated and it’s working, the more anxiety you will build up.
Other discomfort starts coming out like how long this would last.
Korean stock market 50% now is Samsung and SK Hynix.
We don’t even need to talk about how concentrated the United States is.
If you piece all of this together, what should a planner for long term income do? All-in Samsung and SK Hynix?
Elevate and Think in Terms of Income Portfolio Characteristics
A lot of my points highlight two things:
- Diversity in performance drivers.
- A systematic way the holdings can be swap in and out. If you want it to be passive, it has to be done without you.
I want to tie back to the conversations I have with this client adviser.
His discomfort relates to how he sees the portfolio today but its very much related to these things.
If you are concentrated in a sector, what you can swap in and out is limited. What is critical here? its a lack of diversity in performance drivers that is creating the discomfort.
We got to acknowledge that when the concentration is working, we view the portfolio in one way, but when it is totally not working, we don’t feel like looking at the portfolio.
There will be often times when our portfolios feel like puking.
I feel discomfort when I think about some parts of Daedalus and I think that is normal. But if you feel a huge sense of worry, even when your performance is good, I think sometimes you got to acknowledge that you are too concentrated in your income portfolio.
Its important to understand the implication of these criteria. You would keep hunting for the wrong income funds, if you cannot understand them.
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