Outside-IN

When interest rates rise, alternative strategies have chance to shine for income, diversification

As clients clamor for more income, there are eight alternative assets that emerge as viable options

Sep 22, 2015 @ 7:00 am

By Thomas Hoops

Just when the Greatest Generation is clamoring for investment income to ease their golden years, interest rates at 30-year lows in the U.S. — and in negative territory in Europe — are making many traditional generators of retirement income inadequate. Returns under 1% will not beat inflation, let alone put anything appetizing on the family table. If investments like U.S. Treasuries are no longer “safe,” where can investors turn for income to live on?

The outcome is clear: consistent, high income; the difficult question is how to deliver it.

Consider including alternatives as a complement to traditional strategies in an income portfolio. They can help investors take advantage of the only free lunch in investing: diversification. In order to meet clients' income goals, why not search for a more diverse — and higher earning — set of less traditional or “alternative” income-producing assets?

The income portfolio is one of the three “primary colors” necessary for meeting clients' objectives and of equal importance to capital preservation (as discussed in my last article) and growth.

The equity bull market may be ending, and traditional fixed income is increasingly at risk from rate hikes by the Federal Reserve and other central banks. Thus the usual income-generation solutions, like U.S Treasuries, will likely become more volatile and not work nearly as well as investors hope. Fixed income investors have ridden the curve for the last 30 years, but with the secular decline from 14% down to near zero today, that long ride is over. A laddered portfolio of fixed income securities is almost certain to do one thing: run out of money.

(Related read: How alternatives perform vs. traditional investments when markets get wild)

To get more income, clients may have to accept trade-offs, even with broader income diversification. In this portion of a portfolio, there may need to be some tolerance for changes in asset values. For example, to create an income portfolio that targets 6%-8%, investors will need to include securities that are subject to greater market volatility, at least compared to cash and short duration bonds. A 5%-10% drop in asset value will not make clients happy — but the focus should be on the sizeable, consistent income the portfolio generated.

Alternatives can help. They can carry risk, far more than Treasuries, and thus are best accessed with guidance from professional managers. Nonetheless, while “alternatives” take in a lot more than esoteric, high-risk hedge fund strategies, many of these strategies can be downright simple.

If we consider income-producing alternatives to be anything that is not traditional fixed income, the first set of “simple” options for income generation are actively-managed equity products:

• Preferred equities: They may be a bit under the radar, but they can offer highly attractive yields. Since many issuers are in financial services, the capital buffer requirements of Dodd-Frank promise to make them even safer, with potentially increasing yields.

• Dividend stocks: They can generate substantial income with almost clockwork precision. There is risk to asset values, but over full cycles they usually perform at least as well as market average. Alternatives in this class can employ tactical strategies such as focusing on lower volatility dividend stocks to maximize returns and address risks.

• Global equities: Give investors access to other markets that are less correlated with the U.S. and can, in some sectors and regions, offer higher yields. It can mean taking on country and currency risk, but choosing a diverse and healthy group can dampen volatility.

Next is a class of products that are actively managed and structured fixed income strategies:

• Structured credit securities: Have low duration risk and attractive yields. Poor underwriting and high leverage led to bad outcomes in 2008/2009, but with the worst of the housing bubble behind us, defaults continue to reduce as the economy improves. Investors may want to reassess.

• Floating rate securities: Reset as interests rates rise, giving investors protection from almost certain increases in global interest rates. Look for managers with solid track records and the ability to prudently manage leverage.

There are also excellent alternatives in products that had previously been available only to high-net-worth investors:

• Master limited partnerships: They're not all created equal: structures matter. They must distribute most of their income to qualify for special tax treatment, which can bring investors very high income. Their focus is typically on energy infrastructure, which boomed with U.S. shale oil and gas fracking, but valuations have declined recently with the fall of oil prices. Look for managers that have proven they can manage through cyclical changes in energy markets.

• Real estate funds/REITs: Give investors access to a broad range of real estate markets, domestic and international. Income (mostly from rents) usually keeps up with or exceeds inflation and real estate's low correlation to other asset classes enhances diversification.

• Infrastructure funds: Invest in big, high-quality, non-cyclical assets like highways, bridges, tunnels, pipelines and water systems. Income streams are very dependable. Managers with global capabilities are best positioned to find consistently attractive opportunities.

The diversity of this list highlights the fact that, while often advantageous, many alternative investments can be difficult for clients to assess. One source may prove insufficient. To meet clients' immediate income goals and achieve diversification, a multi-manager approach that relies on specialists in each category is the best path to building strong, robust portfolios.

Thomas Hoops is executive vice president and head of business development at Legg Mason Global Asset Management.

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