Yield Seekers: Consider the Total Return Approach

Thanks for joining me, Fran.

Fran Kinniry: Thank you, Jason.

Stipp: First question for you: There is, obviously, a very challenging environment with yield today. I think investors are figuring out, trying to think about how they can squeeze more yield out of their holdings. The first thing I'd like to ask you is, are the traditional income-oriented investments that investors have relied on for years, are they sufficient in today's low-yield environment or do investors really need to start looking beyond those and try to find other vehicles to meet their needs?

Kinniry: At Vanguard, we've long believed in a total return approach, and a total return approach is really just thinking about the total returns of your portfolio and then having a spending strategy that meets your needs. That spending strategy for most investors may be 4% or 5%, even 6%.

So, in today's yield environment, our core bond portfolio, the Vanguard Total Bond Market is yielding somewhere around 2.8%, and if you look at that benchmark, it tracks the Barclays Total Aggregate Bond benchmark. August 31 was the lowest yields in its 35-year history. So the yield environment is very challenging across the board, and we do not believe that searching for yield is going to really be enough for most investors.

Stipp: So I think this raises a good point because yield doesn't come for free. I mean, you have take on more risk to get more yield. So, investors who are hoping to just live off of this income may end up with riskier portfolios than they anticipated. Correct?

Kinniry: Absolutely. So you are seeing some investors gravitate to either high-yield bonds or even extending their duration, meaning from short to intermediate or money market to short. And it looks like a pretty good trade because the spreads or the yields that you get are pretty substantial; but A), you are taking on substantial credit risk in many cases and the duration in many times is two to three times the yield pick-up.

So a small increase, a very small increase in yields or interest rates would make that trade backfire. So, we still believe investors should be looking at the equity markets. The equity markets look much more fairly valued than the bond market and following a total return approach.

Stipp: So, can you just briefly explain how an investor might think about a total return approach in practice in a portfolio? Say, they are in retirement and they hope to generate an income stream. What steps might they take to implement something like that?

Kinniry: Sure. It does not have to be an aggressive portfolio. An investor could have 80% in fixed income, 20% in equities or 30% in equities. So it does not have to be a very aggressive equity portfolio. And then, they would set up an automatic withdrawal program at any one of the providers.

Vanguard has very systematic auto withdrawal programs, and they can attach a percentage that they want sent to them monthly. And it's kind of like getting a monthly check, almost like a social security check sent to you and your portfolio.

The equities will, hopefully, grow much quicker than your drawdown, and in most cases, the equity markets will do that. So we think the equity market is the place to go rather than extending duration or rather than searching for yield in credit bonds.

Stipp: So, back to yield a little bit, and the low-yield environment, do you have a forecast for when we might see this turn around, when we might see interest rates move up? And in that case, how should investors prepare, given that higher interest rates could be detrimental to their existing bond portfolios?

Kinniry: Our current outlook is for actually a very slow recovering economy, with a lot of capacity that's idle, and that leads us to really think that interest rates are going to remain quite low, and that really means an extended period with potentially low yields.

The counter to that is if interest rates do rise--we can't rule that out, that certainly could happen--then you're going to have a negative return. So we really believe right now today that the equity risk premium, equities to bonds, equities to money markets, is a very attractive place to be.

Stipp: Last question for you. This is the ETF Conference, so I want to ask you specifically about ETFs. When you're thinking about how investors may incorporate these into their portfolio strategies, what are some of the advantages of ETFs and what are some of the things that investors should keep in mind if they are having ETFs as part of their overall portfolio strategy?

Kinniry: The number one thing in a low-yield environment is to make sure your costs are as low as possible. And so, we have seen the investment industry, all of the participants in the industry, really voting with their feet, meaning that all of the cash flows have gone into index funds or ETFs or very low-cost funds. If the yields on bonds are 2%, and you are paying 1% for money management, you are giving up 50% of your return.

So the greatest thing about ETFs is also the same thing that is good about low-cost funds: that you're going to keep more of the yield that you are actually earning.

Stipp: Fran, thanks so much for joining me and for your insights today on this yield environment.

Kinniry: Thanks, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.