How to beat the low interest rate

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Greg Davis, Chief Investment Officer, Vanguard Asia-Pacific, explains how to adjust your clients' portfolios to suit the low-interest world:

The global financial crisis forced central banks around the world to dramatically lower interest rates to try and avoid economic depression and subsequently as a way to stimulate economic growth.

Today short-term interest rates are sitting at historic lows, including Australia, with the current Reserve Bank of Australia (RBA) cash rate at 2.5%.

With this lower interest rate environment, bond interest payments and interest from term deposits which may have been serving investors income needs over the past few years are lower than historical averages.

Investors who have become accustomed to living off the interest component of their investment portfolio are facing different challenges because they are not receiving the same levels of yield. These investors may be seeing the only choices available to them as being either accepting a lower standard of living (which most would reject) or changing their investment asset allocations.

So how should investors respond to reduced yield and an absence of adequate income in their portfolio?

Because we believe that an income-only strategy can be damaging to the overall health of a portfolio, at Vanguard we are strong proponents of the concept of total return investing – or investing for cash flow and capital appreciation.

Our research shows this to be a superior approach, in particular for those in the drawdown phase of their investment lifecycle.

This approach advocates keeping the portfolio broadly diversified at a low cost and focused on the overall, or total, return. Where the need for additional income occurs over and above the yield generated by this broadly diversified portfolio, the investor spends the amount made from the overall portfolio – or the total return – rather than switching around holdings to generate additional yield.

There are two key advantages to taking this approach:

  1. The first is that you will maintain the portfolios risk profile through maintenance of diversification rather than, for example, deciding to invest in a narrower, concentrated fund or collection of shares
  2. You allow the portfolio to be more tax efficient which may be something that suffers if you are following an income-only approach through purchasing taxable bond funds or income oriented shares

On a final note, a key thing to be aware of in a low-yield environment is the cost of investment choices – and keeping them as low as possible. If the yields on bonds are two percent, and you’re paying one percent for management, you are giving up 50% of the return.

It has been heartening to see investors to a certain extent voting with their feet in Australia, and choosing more diversified, low cost index funds or ETFs as a core investment choice.