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Income investing calls for more than an ad-hoc approach

Multi-asset income investing allows investors to manage risk


Date: July 02,2014

Savvy investors have always appreciated the value of investing for income.

Less experienced investors may get seduced by the potential of big share price gains in more speculative stocks. But a year or two of fluctuations in the market (and the inevitable disappointments with some of their stock picks) often have them wondering whether there is a better way to invest.

This inevitably leads them to investing for income. The thirst for income investing has even led to some controversies in the Canadian market. The insatiable retail investor demand for income trusts 10 years ago led to one of the most unpopular decisions ever by a finance minister in this country – the late Jim Flaherty’s move to end the tax benefits of most income trusts.

Now most investors make income streams at least part of their portfolio strategy. Many retirees use the income from their investments to supplement their pensions. But all too often they have an ad hoc, piecemeal strategy that can leave them vulnerable to the ups and downs of the market.

Adam Kramer offers up a solution to that. A portfolio manager with Fidelity Investments, Mr. Kramer manages the Fidelity Tactical High Income Fund. He also manages the convertible securities sub-portfolio for Fidelity U.S. Dividend Fund, which is available to Canadian investors.

Mr. Kramer calls his approach “multi-asset income investing.” He aims to provide a high level of current income, while preserving capital and minimizing volatility in down markets. He says “multi-asset income investing allows investors to diversify away from credit risk, equity risk and interest rate risk.”

Mr. Kramer does this by considering the full spectrum of income asset classes, and ranking them by yield and volatility. These range from cash and government bonds, to corporate and high-yield bonds, to preferred securities, dividend-paying stocks and REITs.

Mr. Kramer then gathers research to determine where the economy is in the business cycle, and ranks each of the income asset classes according to their expected rate of return.

For example, early in the business cycle, high-yield bonds, leveraged loans and convertible bonds typically get the “biggest bounce” as the economy recovers. In the middle of the business cycle, preferred securities, dividend-paying stocks and real-estate investment trusts (REITs) have their turn in the spotlight. Late in the cycle, and as the economy may be experiencing a downturn, the best bets are defensive plays such as government bonds, corporate bonds, and even cash.

Mr. Kramer will shift the weighting of the investments he makes in each of these asset classes according to his business-cycle-based ranking. He says this may lead to an average holding period that is shorter than some funds.

While this approach works for him – the fund returned 34 per cent in 2013 – Mr. Kramer acknowledges it would be challenging for individual investors to implement. The total level of capital would have to be relatively high. As well, trading in securities such as government bonds can be difficult for retail investors. He says there are also risks for less experienced investors when it comes to timing the shifts between income asset classes, as well as buying the right securities.

There are other factors for individuals to consider when it comes to income investing. Moshe Milevsky is a professor at the Schulich School of Business at York University. He notes it is important for investors to be focused on “real” returns (i.e. after inflation) rather than the nominal return. As well, the income should be tax efficient, and be set up to last throughout one’s investing horizon (often the rest of the investor’s life).

Prof. Milevsky also says a key for investors to maintain their income investments as market conditions rise and fall is to simply not pay too much attention to market conditions. “Very often ignorance is bliss,” he says. “People tend to over-react, under-react and mis-react.”

Prof. Milevsky also touts the importance of diversification. “Make sure your assets aren’t linked to one factor,” he says. “Make sure your entire balance sheet – not just your investments – are spread all over the economy and its various sectors and factors. The best advice still is: Don’t put all your nest eggs in one basket.”

Getting back to Mr. Kramer’s model, he feels the most attractive income asset classes right now include convertible bonds, equities and some parts of the U.S. Treasury yield curve. However, that preference will inevitably change as Mr. Kramer continues to assess business conditions and shifts weightings to maximize returns and minimize risk, no matter where the market heads next.

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