Income…but at What Cost? - Context

There are a lot of suggestions these days about where to get extra income, but less discussion about the cost attached to it. A diversified multi-asset approach can help—and provide additional growth potential. But how it’s designed matters.

Earning investment income today is a challenge, and it’s not getting any easier. Years of central bank quantitative easing have reduced the supply of income-generating bonds. As a result, yields are very low—and even lower after taxes and inflation.

At the same time, the risks inside income-oriented indices are rising. The duration, or interest-rate sensitivity, of the Bloomberg Barclays Global Aggregate Bond Index has grown by 27% since 2008, leaving investors vulnerable as US interest rates rise. On the equity side, dividend-paying stocks, based on price-to-earnings ratios, are trading at a valuation of 24.0 times earnings. The 40-year average is just 13.9 times earnings.

In fact, many of the areas people turn to for an income boost run the risk of large drawdowns if things go wrong. Real estate is a good example. Over the last 10 years, the average drawdown in Morningstar’s Global Real Estate category was 15% and the biggest was about 60% (Display).

In just about every asset class, investors today must take more risk than they did a decade ago to earn the same level of income. In these conditions, it’s clear that simply piling into income trades isn’t the answer.

Getting a Handle on Risk

Is there a way to generate high and stable income in today’s environment with less risk? We think there is. Of course, “less” risk doesn’t mean “none.” In investing, as in life, nothing is free. That’s why investors must decide how much income they need—and at what cost. In other words, how much can you tolerate losing in a down market?

The next step is to build a strategy that can deliver in all manner of market environments. We think a globally diversified multi-asset approach can help boost income, deliver principal growth and reduce downside risk.

Designing a Multi-Asset Income Strategy: The Requirements

But a lot depends on how such a strategy is designed and managed. The way we see it, investors should want a multi-asset solution to provide breadth, depth and flexibility.

An effective multi-asset strategy should be broad and unconstrained. What do we mean by that? Simply that managers shouldn’t be shackled when it comes to sourcing income and returns. It’s critically important that they can invest in a broad range of assets across the globe.

Breadth of exposure brings diversification of risk, too. For example, mixing in less traditional assets and strategies not highly correlated with global bonds and equities can help avoid large drawdowns and maintain a desired level of all-weather income. And tactical allocations to less traditional income generators beyond bonds and dividend-paying stocks can add growth potential to the mix.

Managers need a deep understanding of the return drivers of every portfolio asset. Even a diversified portfolio can contain common risks. Too many multi-asset managers today use a bolt-on approach when building a portfolio: they toss many single-asset strategies into a single portfolio and manage them separately. This can overexpose investors to specific types of risk without their knowing it.

For example, dividend-paying stocks, real estate investment trusts and investment-grade corporate bonds are typical components of most income-oriented portfolios. What may not be clear to everyone is that all three also carry significant interest-rate risk.

Unsurprisingly, they all struggled in the first quarter of 2018 as worries about tighter monetary policy and future inflation caused a sudden and sharp rise in US Treasury yields. Managers who take a more integrated approach stand a better chance of identifying and hedging the common risks that creep into a portfolio.

Multi-asset solutions need to be dynamic and flexible. The ability to adjust quickly is always important. But it’s especially so today. As we’ve already seen, investors globally are still chasing yield in ever more crowded trades. But interest rates are rising, and long bull runs in many asset classes are losing momentum. These could lead to sudden shifts in investor behavior. Being able to pivot quickly as conditions change is important.

A dynamic approach also helps determine when to establish strategic positions in assets with reliable long-term track records and when to take opportunistic short-term positions that can help in specific market conditions.

There are always going to be trade-offs between generating high and reliable income and the potential principal cost from losses. The more comfortable investors are with their exposure, the more likely they are to avoid the crowds and stick with a diversified strategy that can deliver over the long haul.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.