CFA Institute Journal Review August 2015 Volume 45 Issue 8
Building Efficient Income Portfolios (Digest Summary)
Journal of Portfolio Management
Investors’ appetites for risk have been waning as a result of changing demographics and increasing market volatility. The authors provide a framework to construct an income-focused portfolio as the demand for reliable current income increases. Income-oriented portfolios are somewhat less diversified than traditional total-return portfolios, but they can expect to generate higher levels of income than total-return portfolios.
Traditionally, most portfolio optimization has focused on total-return analysis to the exclusion of income-oriented portfolios. Given the change in investor risk appetite as a result of the 2008 credit crisis, increased market volatility, demographic shifts, and the belief that growth rates will be lower going forward, the interest in income-focused portfolios has been increasing. Needing to use the income the portfolio generates while preserving the principal, investors who are at or near retirement are increasingly seeking income-generating portfolios and focusing on more predictable returns. Total-return portfolios generate income but may not be ideal for these investors. Yet there is only modest guidance available on how to build an efficient income-generating portfolio compared with the guidance available for total-return portfolios.
How Is This Research Useful to Practitioners?
Although demand for income-focused portfolios may be strong, generating consistent income is not easy because the ideal investment allocation for these investors is not well-defined. There is more than one solution, but the authors believe a multi-asset income-oriented portfolio—a mix of guaranteed and capital market assets—is a fundamental element for most retirement portfolios.
Historically, the income variability for both stocks and bonds has been significantly less than the price variability. The standard deviation of income returns for stocks (bonds) has been 1.63% (2.84%) versus a standard deviation for price return of 19.38% (8.74%). Investors who want low-income fluctuation, have modest liquidity needs, and accept high levels of principal fluctuation can benefit from an income-focused portfolio.
Considering both an income-return portfolio and a total-return portfolio each with a 7.5% expected return, the authors find that the income-return portfolio produced only a slightly lower Sharpe ratio of 1.02 versus the total-return portfolio’s ratio of 1.05 while generating an additional 140 bps over the total-return portfolio. This slightly lower Sharpe ratio should not concern income-oriented investors because they place more importance on income predictability than total-return efficiency. In addition, as would be expected, the income-return portfolios are less diversified than the total-return portfolios, primarily because of the income restraint that limits the opportunity set.
Although the income-return portfolios have fewer asset classes, they nonetheless demonstrate reasonable diversification. When factoring in taxes, the allocation to equity investments dramatically increases for both portfolios. The authors’ investigation also uncovered that investors who are less wealthy will derive the greatest utility from the income-focused portfolio as a result of comparatively low income brackets. On the basis of the analysis, investors who want to construct an income-efficient portfolio should consider using high-yield bonds, international bonds, and emerging market bonds in addition to the more traditional long-term and short-term US bonds.
How Did the Authors Conduct This Research?
The authors decompose the efficient frontier into its respective parts: income return and price return. They contrast an income-oriented portfolio with a total-return portfolio that ranges in expected returns from 4.5% to 8.0%. The analysis includes 19 major asset classes covering the period from October 1997 to December 2014. Each equity class is constrained to a maximum of 30%, whereas each bond class is limited to 40%, with the exception of short-term bonds that are unconstrained.
The authors use stylized examples to contrast the efficient-income frontier with the total-return frontier. In addition, by incorporating taxes, the analysis reveals the substantial impact that taxes have on the relative attractiveness of certain asset classes. Both the income-oriented portfolio and the total-return portfolio allocation toward equities increases dramatically when taxes are considered because qualified dividends are treated preferentially to bond interest. A common criticism of constructing a portfolio that focuses on generating income is that it will not be as efficient as a total-return portfolio when viewed within a total-return framework. Although this view may be true to some degree, it does not consider the current consumption and income needs of the investor.
The authors propose a framework for determining how to build an income-oriented portfolio. As the US population continues to age and people’s ability to accept risk (income volatility) diminishes, the demand for efficient income-oriented portfolios is becoming increasingly important. Further research into income-oriented strategies, practical portfolio implementation, and innovative products to address this challenge would be well received by investors and financial advisers alike.