How portfolio diversification can help deliver more income to clients

Is it just me, or has it gotten harder to build a decent investment portfolio?
Equity markets are near all-time highs after a long and extended run. Much of fixed income has followed the Federal Reserve down close to zero. Europe’s problems with deflation and defaults continue, and China’s double-digit growth could take a nose dive, while many emerging markets remain as inscrutable as ever.
Building portfolios that serve clients’ needs has gotten harder because of two big changes: interest rates are persistently low globally, and demographic shifts have created aging populations, particularly in developed countries. This large and rapidly growing elderly cohort needs income, and yet the countries where most of these investors live have low interest rates due to low GDP growth — which stems in part from their aging populations. The circle of life.
As a result, many asset managers talk about the need to look for broader sources of yield. That begs the question of how best to put the pieces together in possibly new and different ways, generating returns and/or income while still managing volatility.
Passive instruments alone are not the answer, since they are by their nature 100% correlated to the markets and lack the tactical ability to adapt. What happens when their markets start going down, or even sideways? We focus on diversification within our income and growth solutions so that when markets have bad weeks or horrible quarters, clients suffer less volatility and can remain on track toward reaching their goals.
(Related read: How to manage equity market uncertainty)
But the reality is today’s low-rate environment makes income generation a challenge. Even if interest rates rise in the short term, it could be some time before inflation-adjusted coupons make significant moves.
How can financial advisers use diversification to help deliver greater income to clients?

The Diversification Effect

In asset classes known for their income potential, diversification counts: holding a variety of asset classes can help reduce overall volatility while still supplying current income.
Diversification within income solutions requires learning to go beyond traditional fixed income, the familiar income-producing classes such as U.S. Treasuries, corporate bonds and dividend stocks. For the foreseeable future, those yield fields will likely remain fallow.
This has led many investors to explore less traditional income and distribution sources such as high-yield bonds, REITs, MLPs and emerging-market debt, as well as to utilize more flexible investment strategies such as unconstrained mandates and absolute-return credit.
There is a natural tendency to focus on the specific risks and returns inherent in each of these sectors. But what about their contribution to the volatility of an investor’s overall portfolio?
The diversification effect — the potential reduction of portfolio volatility generated by adding additional strategies — can be illustrated in the combination of indexes that focus on asset classes with higher income components. It is often just as clear as in the broad stock and bond indexes investors traditionally rely upon.
For instance, the S&P 500 Dividend Aristocrats Index, comprising companies in the S&P 500 that have increased their dividends for at least 25 consecutive years, shows very low correlation with the lower-income Barclays U.S. Agg (0.032). It shows a higher, but still low (0.491), correlation with the Barclays U.S. High Yield Index.
As many of us know all too well, diversification does not assure returns or protect against loss of capital. During some market upheavals, its effects can be blunted despite the best modeling. Nevertheless, the relatively reduced volatility of combining asset classes that deliver higher income is clearly observable in historical data.

Diversification, Income and Rising Rates

Since the Fed lowered benchmark interest rates to near zero, income-oriented investors have waited for rates to rise — with a combination of anticipation and dread. Anticipation, because those who need current income have been hard-pressed to find it. The dread reflects fears that the drop in the prices of fixed-income instruments will not make up for the pickup in current income.
These reactions are entirely reasonable. Reducing the volatility of returns is not the only objective for investors. For example, focusing on enhancing or protecting streams of income could increase the willingness of some clients (although most assuredly not all) to endure losses in invested principal, to keep that income stream stable.
The better trade might be to sacrifice current income for a reduction in capital risk. With interest rates at lower-than-low levels, buyers of “risk-free” Treasury bonds may have to forgo meaningful income. For them, rising rates could be a blessing, creating opportunities to increase income from future investments.

Lunch May Not Be Free, But It Offers Some Tasty Main Courses

Wide varieties of income-producing asset classes can be used, each with its own return and risk characteristics, different from each other as well as from benchmark indexes. The general principle of retaining return while reducing volatility — or controlling volatility while seeking to increase return — can hold just as true for income asset classes as for others.
That’s good news when seeking to maintain allocations to income-oriented investments, including both equity and fixed-income assets. No one knows what the future holds for financial markets, whether it’s rising rates, economic surprises or unpleasant geopolitical events.
Diversification clearly cannot assure profit or protect against loss. Nonetheless, diversification in income-producing asset classes can offer customized tradeoffs between volatility and income benefits that provide meaningful choices to meet a variety of investment goals.
This only underscores that, to meet the needs of our demographically shifting clients, these low-rate, challenging markets require creativity, knowledge and skill to navigate successfully.
It’s a tall order — but isn’t that what we get paid for?
Thomas Hoops is executive vice president and head of business development at Legg Mason Global Asset Management.