In the current low interest rate environment, some investors are searching for income by taking unintended bets with their portfolios, embracing instruments and financial strategies which are often inappropriate, misunderstood, or just plain destructive to value. As a result, they may be inadvertently introducing under-appreciated risks and unnecessary volatility without a commensurate increase in return.
So how should one invest for income in today’s low yield environment? When it comes to income, we would emphasize the following portfolio construction guideline: Focus on the level of desired return. The desired return, rather than where it comes from (i.e. income or capital gains), should determine the composition of the portfolio.
This guideline is based on our analysis of a series of hypothetical portfolios designed to generate a range of target returns by combining investments that provide different levels of income. We started with a simple portfolio of around 70% fixed-income and 30% equities, no preference for income, and a modest annual return of around 6%. We then compared this portfolio with others that had increasing preferences for income.
The result: portfolios with a low preference for income over capital gains were not materially less efficient – in other words, the returns they generated relative to their level of risk were not substantially different than the initial portfolio. In contrast, as our hypothetical investor started to demonstrate a much stronger preference for income, the portfolio became materially more risky per unit of desired return.
The explanation for this result is simple: as the preference for income increases, assets that generate low levels of income are ‘pushed out’ of the portfolio — even if they provide diversification benefits. As the investor forgoes the diversification benefit of holding asset classes with low income components (such as growth equities, for example), the portfolio becomes more risky per unit of total return. Indeed, the cost of the preference for income is the additional risk that must be taken in the portfolio as a result of this reduced diversification benefit.
In light of these findings, what practical steps should investors take in building portfolios and thinking about income? First, begin with an explicit return target. This will help frame the significance of the income versus efficiency trade-off. Second, leave income producing investments in more conservative portfolios. If investors insist on both return and income they may have to accept a pick-up in volatility.
Potential iShares Solutions
|Dividend stocks||DVY – iShares Dow Jones Select Dividend Index Fund (click here for fund details)|
|Preferred stocks||PFF – iShares S&P U.S. Preferred Stock Index Fund (click here for fund details)|
|US long term Treasuries||TLT – iShares Barclays 20+ Year Treasury Bond Fund (click here for fund details)|
|US Short Term Treasuries||SHY – iShares Barclays 1-3 Year Treasury Bond Fund (click here for fund details)|
|US Large Cap||IWB – iShares Russell 1000 Index Fund (click here for fund details)|
|US Small Cap||IWM – iShares Russell 2000 Index Fund (click here for fund details)|
Listen to the full March Market Perspectives by Russ Koesterich here.
The author is long DVY, PFF, and IWM.
In addition to the normal risks associated with investing, investments in smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise.
The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy.