Apply a holistic approach when funding cash needs and challenges
Institutions and nonprofit organizations, often rely on funding a percentage of their annual operations through their investments. Historically, many organizations generated funds using a “yield” or “income” approach. However, a “total return” approach may be a more efficient way to generate cash flows.
The yield approach funds cash flow needs primarily through interest and/or dividends from securities. The appeal of dividends/interest comes from a belief that securities paying income are less risky because they offer a regular stream of payments to investors. However, a yield approach may be more volatile than some might think.
First, for institutions that are primarily invested in fixed income, market interest rates can fluctuate, so cash flows generated can vary over time. In addition, recent yields have been a wake-up call for organizations trying to keep up with previous funding needs and inflationary pressures.
Second, when relying on dividend paying stocks, it is important to remember that dividend payments are paid from a company’s earnings or assets, which are reflected in the current stock price. Employing a high dividend yield strategy does not protect against encroaching on capital to generate cash flow unless a dividend distribution is reinvested rather than spent. Another common misconception is that dividends offer downside protection by mitigating the impact of a falling stock price on the portfolio. For example, a stock that yields a 5% dividend can decline by up to 5% before the investor experiences a negative total return. However, since a dividend paid reduces the stock price by the same amount, any additional non-dividend related price decline would result in a negative total return.
Finally, institutions using a yield approach should be aware that holding a portfolio that emphasizes dividend-paying stocks may negatively impact diversification and expected returns. Research concluded that:
A global portfolio of dividend-paying stocks would have similar average returns to a portfolio of non-dividend-paying stocks. However, a dividend-focused portfolio would exclude 35%–40% of stocks globally, resulting in lower diversification…In addition, global portfolios holding only dividend-paying stocks exclude about 47% of the available small cap stock universe, which historically has offered higher average returns than large cap stocks.1
The alternative is a total return approach, which involves selling assets in the portfolio to create cash flow. This method reflects the idea that, from an investment standpoint, it makes little difference whether returns are delivered as dividends or capital gains.
Implementing a total return approach allows organizations to develop a sustainable withdrawal strategy rather than letting portfolio yields determine spending rates. There is greater control over the timing and amount of cash flow generated, and the added benefit of the ability to create opportunities to strategically rebalance by selling assets that are over weighted relative to the target allocation.
Footnote:
- Black, Stanley. March 2013. “Global Dividend-Paying Stocks: A Recent History.” Dimensional Fund Advisors white paper.
