Incoming! Part 1: Basics of Investment Income Generation

Money, get away. Get a good job with more pay and you’re okay.” Pink Floyd, Money

The burden of generating retirement income is now placed on individuals, as traditional pension plans have largely gone away. Thus, in the words of Mr. Floyd in the opening quote, getting “a good job with more pay” to earn money in excess of one’s expenses and increase savings has become fundamental for building an adequate retirement nest egg. Don’t worry, I’m joking. Pink Floyd is no more a person than Lynyrd Skynyrd (and if you don’t know these are bands, please enlighten yourself and thank me later). Anyway, once savings have been accumulated, the money has to be managed in a way that can create adequate retirement income, and THAT is what we’re going to begin talking about today:  how different investment options generate income and how that income is distributed to investors.

So Many Options…

As a reader of Alt Blend, you’re likely already familiar with many different types of investments and distribution terms like interest, dividends, capital gains, and return of capital. What are the similarities and differences between different types of distributions? How do distributions affect the value of an investment? What are the tax implications? Let’s examine several of the most common investment types at a more nuanced level in hopes we may learn something about the income end-investors receive. And to provide a basis for understanding the income distributions of Alts, we’ll start with plain vanilla publicly-traded investments.

The Basic Building Blocks of Investment Distributions

Interest (Bonds): When we buy a bond, we’re actually lending our money to someone or some thing (like a company or the government) in exchange for payments, which is known as interest. That concept is true of any situation where you (the investor) are compensated for providing debt capital. While the interest payments could be used to buy additional bonds – and, perhaps, even more of the same bonds – automatic reinvestment isn’t “a thing” when owning individual bonds.

Dividends (Stocks): When we buy a share of stock, we take an ownership stake in a company. When the company generates profits, it can share that success with investors by paying a dividend. In the case of dividends, investors can choose to have that money reinvested automatically into more shares of the same company, or they can take it in cash and do whatever they want with it. Note: For the purposes of this discussion, I’m lumping royalties and revenue sharing into this category for this initial discussion (it’s income from ownership of something) but will add some differentiation later.

Capital Gains (Profits): Aside from paying interest and dividends, if stocks and bonds (or many other investments) increase in value and are then sold, this can generate another form of income (aka “realized capital gain”).

Return of Capital (Partnerships): This is precisely what it sounds like – i.e., giving investors’ money back – and it really comes into play once we get into partnership structures. I’ll give a quick shout-out here to master-limited partnerships (MLPs), as many investors own them. They look and trade A LOT like stocks but can involve some different attributes, such as return-of-capital (ROC) distributions, because they’re a sort of hybrid between a private partnership and publicly traded stock. I don’t think we need to go too far down the MLP rabbit hole for this particular topic, but here’s a link to learn more about them, if you’re interested. Many private Alts are also structured as partnerships and can involve ROC distributions.

Combinatorics

In addition to the basics of standalone stocks and bonds, many other packages and combinations of investments are available. The following is a very brief refresher on some of the possibilities.

Mutual Funds: since a mutual fund is just a pool of money, it can own various underlying investments. For starters, there are bond funds (that hold a mix of bonds), equity funds (that hold a mix of stocks), balanced funds (that hold both stocks and bonds), and index funds (based on an underlying index, like the S&P 500). However, they can become much more complex, with mandates ranging from real estate to commodities, managed futures, options, derivatives, currencies, hedging, private investments (e.g., direct lending or private equity), and even funds of other mutual funds. And, as you may have already guessed, they can also hold MLPs. An important characteristic is that the price of mutual funds is only updated at the end of each trading day.

Exchange-traded Funds (ETFs) and Closed-end Funds (CEFs): Like mutual funds, ETFs and CEFs can hold many types of underlying investments. CEFs can also be a way for private investments to move into publicly-traded markets, which often happens with BDCs (business development companies). Both ETFs and CEFs are conceptually similar to mutual funds because they’re pools of assets. Still, they’re also very different when it comes to trading (as they trade intraday, like stocks) and the intricacies of distributions.

Alts: As we’ve covered in past editions of Alt Blend, typical alternative investment structures include LPs (limited partnerships), LLCs, REITs (real estate investment trusts), private BDCs, and interval funds. Investment into these funds may be immediate or take several years, they may price daily, monthly, quarterly, or even less frequently than, and liquidity ranges substantially.

Aside: as an engineering major at Penn State, I was reasonably proficient at calculus, physics, and statistics, but I vividly recall combinatorics class (aka Math 310) being notably elusive and frustrating to me. It was some sort of advanced abstract probability, like the problem “If a room has 21 people in it, prove that 2 of those people have the same birthday.” Just the word “combinatorics” still renders some deep-rooted discomfort to this day. A quick Google search resulted in the Quora question, “why is combinatorics so difficult?” so clearly, I’m not alone.

Distributive Properties

Bringing this back to the basics – just like stocks and bonds – all of the above structures are ultimately used to lend money or own things, either directly or indirectly. Thus, no matter how complex the strategy or structure, the distributions that investors receive will be some combination of interest, dividends, capital gains, and return of capital. And now that we have the general lay of the land, we can officially turn our attention to the mechanics of distributions in part 2 of this series, which will also address some common areas of confusion.

Until next time, this is the end of Alt Blend

Thanks for reading,

Steve

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About the Author

Steven Tresnan, CAIA®, CFP®

Private Wealth Advisor

Steve is a Certified Financial Planner as well as a Chartered Alternative Investment Analyst®. He is also an Accredited Investment Fiduciary, which helps him offer guidance to clients with fiduciary responsibilities, such as board members of trusts, foundations, and endowments. Steve earned a Bachelor of Science degree in Industrial Engineering from Penn State University.

Steve serves on the board and finance committee of New Music USA – a national nonprofit devoted to the development and appreciation of new music in the U.S. – and volunteers as the Treasurer for Campus Fun & Learn, a child development center on the campus of Rockland Community College in New York. 

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