Be Flexible and Cast a Wider Net for Income
Michael Fredericks | January 22, 2014 | Topics: Investing for Income
Point of View With Michael Fredericks
- Investors starved for income need to look outside of traditional income sources.
- Employing a tactical asset allocation strategy can expand opportunities while helping manage volatility.
- Investors should consider incorporating an actively managed portfolio seeking a diversified mix of alternative income sources.
With interest rates still near historic lows and risks looming over portfolios, investors are starved for investments that provide income with less volatility. To help identify a better approach, Michael Fredericks, portfolio manager of BlackRock's Multi-Asset Income Fund, suggests employing a flexible strategy that goes beyond traditional income asset classes.
- A wider set of income opportunities exists beyond traditional fixed income sectors, and can provide higher yields and diversification.
- A go-anywhere tactical asset allocation strategy can take advantage of volatile markets to expand income and return opportunities while managing portfolio volatility.
- As market risks evolve, investors should consider relying on a manager who takes a global best-ideas income approach that carefully considers risk.
Why and how should investors rethink their income strategy?
We believe the traditional benchmarked 60%/40% equity/fixed income portfolio offers too little income and too much risk. To rethink your portfolio, we suggest going outside traditional stock and bond sources of income to alternative sources of income to diversify so that not all of the portfolio's investments move in the same direction at the same time, particularly on the downside. This approach requires deep resources and expertise to successfully uncover the wide range of potentially complex investment opportunities across the full array of asset classes.
Income investing is challenging today. What do you suggest?
Balancing income and risk could be the biggest challenge for investors today. Yields are near historic lows, but have been volatile with wide ranges across asset classes. With yields so low, conventional wisdom says that investors need to stretch into higher-risk sectors and asset classes to achieve higher income and return potential. But with markets volatile, moving into riskier asset classes is about the last thing any income investor wants to do. As such, we recommend all investors, including savers and retirees, reassess their income strategy to consider a wider range of income sources through a flexible approach.
We recommend all investors, including savers and retirees, reassess their income strategy to consider a wider range of income sources through a flexible approach.
What are alternative sources of income?
Our approach is built upon the belief that actively managing a diversified mix of alternative income sources with traditional sources such as bonds and dividend equities (see below) can offer attractive risk-adjusted income. Alternative sources of income include non-traditional asset classes such as Master Limited Partnerships (MLPs), preferred stock, real estate investment trusts (REITs), and emerging market debt.
These asset classes can help generate an attractive yield in a low rate environment. But these are asset classes that are difficult to analyze and invest in, so we believe doing so through a fund manager who has expertise across the range of alternative income asset classes and strategies is important.
What is your outlook for income markets in 2014?
The Fed's easy monetary policy, combined with investors' continued thirst for yield, has caused many income-producing sectors of the market to appear expensive relative to their historical averages. In particular, the threat of rising interest rates (and declining prices) looms over longer-dated bonds. In addition, massive inflows into higher-yielding credit sectors of the bond market have lifted prices to near all-time highs, and equity volatility is likely to increase from recent lows, in part due to continued political uncertainty. In spite of these challenges, investors will continue to need income in this prolonged low-interest-rate environment. For investors searching for yield, we believe opportunities exist in select segments of both equity and bond markets (as well as in other asset classes). Over the coming year, it will be more important than ever for investors to work with a manager who has a high degree of flexibility to effectively manage a well-diversified income portfolio.
Does the potential for rising interest rates factor into your income strategy?
Absolutely. This is a major concern for many investors in today's market, particularly income investors. For the better part of the last few decades, fixed income investors have enjoyed positive returns and yields as a result of the declining interest rate environment. With the recent interest rate volatility and the potential for rates to move higher in the future, the landscape for generating income has changed dramatically. Today, income investing requires significantly greater flexibility, particularly when looking at the bond side of a portfolio. The issue is that many income strategies out in the market simply do not have the necessary flexibility to manage a portfolio effectively in this new environment. We believe investors should look for a manager who has the ability to mitigate interest rate risk. In our income strategy, we have the ability to implement a variety of strategies designed to defend against rising rates and are always looking at the full market environment to determine the most effective approach.
What income sources do you favor?
Even with the recent rise in interest rates, the opportunities for yield are a bit smaller. However, we believe equity valuations remain attractive and will selectively add to our stock exposure. We also think that preferred stock currently provides attractive income and diversifying sector exposures. Finally, we have begun to increase exposure to Europe, both on the equity and bond sides. Europe continues to face a number of headwinds in its economic recovery, but economic data has begun to improve, the European Central Bank has provided necessary stimulus to improve the banking system, and due to investors' fears of the region, valuations look more attractive heading into 2014 than many other regions around the globe.
Also, over the course of the past six months, we have reduced our allocation to emerging markets equity and debt. While these asset classes still offer diversification and income benefits, these positives are being outweighed by heightened volatility and underperformance.
Master Limited Partnership (MLPs) — These are enterprises that trade on an exchange with a tax-advantaged status, usually deriving income from the extraction and transport of natural resources. MLPs typically pay quarterly distributions.
Emerging Market (EM) Debt — This category represents the bonds issued by less developed countries (such as China, Mexico, Bulgaria, Turkey and Russia), and tends to have a lower credit rating than other sovereign debt based on increased economic and political risks. In turn, the yields have a tendency to be higher.
Real Estate Investment Trusts (REITs) — These tax-advantaged entities primarily invest in real estate, deriving most of their income from rental payments, gains from property sales, and other related sources.
Preferred Stock — "Preferreds" are securities that share characteristics of both stocks and bonds, paying a dividend but not granting voting rights to the holder. They are subordinate to bonds but senior to common stock in their claim to assets of the company.
Bank Loans — These loans typically finance leveraged companies, and offer an interest rate that "floats," or gets reset, on a regular basis based on a benchmark such as LIBOR. This floating-rate feature makes the loans relatively insensitive to movements in interest rates.
Special Situation Debt — Credit-related investments that may become available as a result of asset sales, institutional risk reduction or regulatory reasons.
How can investors gain access to all of these income sources?
To construct portfolios incorporating the range of income sources while not taking on excessive risk, it is important to have a dynamic strategy. We believe employing tactical asset allocation (TAA) with a go-anywhere mandate is the best approach. TAA is an active management strategy in which the manager continuously rebalances portfolio asset class allocations in order to take advantage of risk, return and income opportunities. This strategy allows the manager to seek the best income opportunities globally while also managing volatility to provide a complete and balanced approach. While asset allocation strategies do not assure profit or protect against loss, TAA can adapt to challenges while seizing opportunities and we believe offers a better way to improve an investor's income stream, while also reducing the volatility of the portfolio.
A major advantage of TAA is that a manager is able to take a more diversified approach to portfolio management in an effort to control the overall risk of the portfolio and target more consistent results. Using a risk-controlled process, the TAA manager is able to actively rebalance portfolios to find relative value, gain exposure to more attractive asset classes, reduce volatility and potentially increase returns. In this respect, professional managers have enhanced access to information, research and analysis that can help them anticipate economic cycles and better allocate multi-asset class portfolios. The chart below shows the dynamic nature of portfolio allocations within the shifting market environment.
We believe taking a go-anywhere approach is critical to allowing an experienced manager to choose the best opportunities to balance income and risk. The flexibility of a go-anywhere tactical approach means that benchmark allocations are not weighing down the portfolio with low yield, high volatility asset classes.
What is your perspective on portfolio volatility?
We feel very strongly that a "one-stop-shop" income solution is capable of closely managing volatility, and provide investors with a more consistent experience (see chart above). Our strategy of diversifying an income-oriented portfolio by incorporating alternative asset classes that are less correlated they (don't rise or fall at the same time in the same way) to traditional stocks and bonds helps reduce some volatility. As volatility increases we will tactically reduce exposure to riskier assets and add more to positions that demonstrate lower risk profiles. Similarly, as volatility stabilizes, we will allocate to higher risk assets.
We recommend all investors, including savers and retirees, reassess their income strategy to consider a wider range of income sources through a flexible approach.
What risk management do you employ?
Risk management has long been embedded in BlackRock's culture. Our risk management processes include daily risk reviews and stress tests, weekly portfolio construction discussions and monthly senior management reviews of performance and risk levels. Through this comprehensive approach, investment decisions in all our client portfolios are made with an eye toward understanding how each decision might impact the portfolio's overall risk profile.
In today's policy-driven economy it is important for us to consider the proper timeframe with which to view risk. We have observed that conservative, income-oriented investors are typically more sensitive to market fluctuations, particularly short-term pullbacks that may cause their investments to experience sharp negative returns. For this reason, we place a particular emphasis on monitoring and managing short-term volatility in order for us to more effectively adapt to rapidly changing market conditions.
How should an investor incorporate this income strategy in a portfolio?
No matter the environment, risk-averse income investors in search of a one-stop-shop should consider a professionally-managed, flexible income strategy to help enhance the durability, longevity and overall success, of their entire portfolio. We believe a flexible, risk-aware strategy that incorporates alternative income sources can potentially increase income and diversification while decreasing volatility of the entire portfolio.
One approach we suggest is to use an all-in-one flexible income strategy to replace some of the higher-risk equity allocation, and a similarly-sized portion of low yielding fixed income (see pie charts). In addition, for investors who may have too high an allocation to cash or traditional bond strategies, this flexible income approach could be a worthy complement to an overall portfolio. Any portfolio reallocation should take place within the context of an investor's goals, risk tolerance and time horizon.
About the Author
Managing Director, Head of US Retail Asset Allocation for BMACS Group
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* Total returns as of 12/31/13 for BlackRock Multi-Asset Income Fund Investor A shares with maximum sales charge: 1 Year, 3.34%; 5 Year, 11.44%. Since Inception, 5.45% (annualized since fund inception 4/7/08). Total returns with sales charge reflect the deduction of current maximum initial sales charge of 5.25% for Investor A shares. Category average returns for the Morningstar Intermediate Term Bond Category are: 1 year performance, -1.42%; 5 year, 6.31%. Category average returns for the Morningstar World Stock Category are: 1 year performance, 25.19%; 5 year, 15.72%. Index performance is shown for illustrative purposes only. You cannot invest directly in an index. Volatility represented by standard deviation, which measures the volatility of the fund's returns. Higher deviation represents high volatility.
Represented Indexes: US Treasury: Barclays US 7-10 Year Treasury Bond Index. Core bonds: Barclays US Aggregate Index. Investment grade bonds: Barclays Investment Grade Index. High yield bonds: Barclays HY 2% Issuer Capped Index. Floating rate loans: S&P Leveraged Loan Index. US equity: S&P 500 Index. Global equity: MSCI World Index. High Dividend Equities: MSCI USA High Dividend Yield Index. Preferred stock: S&P US Preferred Stock Index. US REITs: FTSE NAREIT Equity REIT Index. MLPs: Alerian MLP Index. International REITs: FTSE NAREIT ex-US Equity REIT Index. EM debt: Barclays Emerging Market Debt Index.
Data represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than that shown. Refer to www.blackrock.com for current month-end performance. Total/net annual operating expenses as stated in this fund's most recent prospectus: Investor A shares are 1.30%/0.80%. The fund's net operating expenses exclude acquired fund fees, investment interest expenses, if any, and certain other fund expenses. BlackRock has contractually agreed to waive or reimburse certain fees and expenses until 11/30/13. Contractual waivers terminable upon 90 days' notice.
Investment involves risks. Stock and bond values fluctuate in price so the value of your investment can go down depending on market conditions. The two main risks related to fixed income investing are interest-rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Investments in non-investment-grade debt securities (high yield or " junk" bonds) may be subject to greater market fluctuations and risk of default or loss of income and principal than securities in higher rating categories. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments in emerging/developing markets or smaller capital markets. Incorporating alternative investments into a portfolio may involve substantial risk and presents the opportunity for significant losses including in some cases, losses which exceed the principal amount invested. Also, some alternative investments have experienced periods of extreme volatility and in general, are not suitable for all investors.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are those of the portfolio manager profiled as of January 15, 2014, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that may, in certain respects, not be consistent with the information contained in this report. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.
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