Author: Nicholas Millikan
Date: November 26, 2014
Category: Financial Planning
Tags: asset allocation, global diversification, investment strategy, mult-asset income, portfolio construction
In my travels, I have had the opportunity to speak with advisors across the country who utilize multi-asset income (MAI) strategies to replace the lost income of traditional fixed-income investments. And while many of them have been more than happy with the results, they have struggled with how to implement MAI strategies within a globally diversified portfolio. Can MAI strategies replace traditional fixed income in a portfolio? Do they displace a portion of equity since the underlying asset classes include income-paying equities? Is traditional fixed income even necessary anymore? The simple answer to each of these questions is “yes,” but let’s look at each in more detail.
To ease the comparison, I’ve constructed a hypothetical globally diversified portfolio including asset classes represented by the indices shown in the table below and looked at a 10-year time period ending September 30, 2014. In addition, I have created a hypothetical conservative MAI strategy that targets a maximum 6.5% standard deviation.
| Global Portfolio | |
|---|---|
| Barclays U.S. Aggregate Bond Index | 40% |
| MSCI ACWI ex-USA Index | 10% |
| Russell 2000 Index | 10% |
| Russell Midcap Index | 10% |
| S&P 500 Index | 30% |
| Total | 100% |
Before we get started, let’s take a look at the compelling yields available with an MAI conservative portfolio in comparison to traditional fixed income (Barclays U.S. Aggregate Bond Index), equity (S&P 500 Index) and a globally diversified portfolio to remind ourselves of the core benefit of MAI strategies.
Replacing traditional fixed income
By replacing the 40% exposure to traditional fixed income in the globally diversified portfolio at 5% increments, we can see some immediate benefits of employing MAI during this time period (see chart below). Income starts to increase with the first 5% allocation, as does the total return. While price appreciation declines somewhat, this is compensated by the added income. A point to note on the price return of the global portfolio is that the declining interest rate environment over the period boosted price return as compared to traditional fixed income securities. As we move to a rising rate environment in the coming years, this additional return is not expected to be as significant. Risk does increase somewhat in the period illustrated, but remains compensated for in the additional total return as the Sharpe ratio stays constant at around 0.96.
Based on Annualized Returns
| 0% MAI Con. |
5% MAI Con. |
10% MAI Con. |
15% MAI Con. |
20% MAI Con. |
25% MAI Con. |
30% MAI Con. |
35% MAI Con. |
40% MAI Con. |
|
|---|---|---|---|---|---|---|---|---|---|
| Total Return | 5.87% | 5.98% | 6.08% | 6.19% | 6.30% | 6.40% | 6.51% | 6.62% | 6.73% |
| Price Return | 3.04% | 2.98% | 2.92% | 2.86% | 2.80% | 2.75% | 2.69% | 2.63% | 2.57% |
| Income Return | 2.76% | 2.93% | 3.10% | 3.27% | 3.43% | 3.60% | 3.77% | 3.94% | 4.10% |
| Standard Deviation | 4.32% | 4.43% | 4.54% | 4.65% | 4.78% | 4.90% | 5.04% | 5.17% | 5.31% |
| Sharpe Ratio | 0.96 | 0.96 | 0.96 | 0.96 | 0.96 | 0.96 | 0.95 | 0.95 | 0.94 |
Replacing equity
Now, let’s turn to equity exposure. Replacing this exposure at 10% increments creates a very interesting result. The total return remains almost the same but it includes an ever-increasing amount of income, again, at the cost of price return. The effect of including MAI also reduces the overall risk of the portfolio, as exhibited by a lower standard deviation. This leads to a more attractive risk/return tradeoff because return stays consistent while the Sharpe ratio increases consistently with each increase in MAI exposure.
Based on Annualized Returns
| 0% MAI Con. |
10% MAI Con. |
20% MAI Con. |
30% MAI Con. |
40% MAI Con. |
50% MAI Con. |
60% MAI Con. |
|
|---|---|---|---|---|---|---|---|
| Total Return | 5.87% | 5.87% | 5.86% | 5.86% | 5.85% | 5.85% | 5.84% |
| Price Return | 3.04% | 2.55% | 2.06% | 1.57% | 1.08% | 0.59% | 0.10% |
| Income Return | 2.76% | 3.26% | 3.76% | 4.25% | 4.75% | 5.24% | 5.74% |
| Standard Deviation | 4.32% | 3.99% | 3.70% | 3.46% | 3.28% | 3.18% | 3.15% |
| Sharpe Ratio | 0.96 | 1.04 | 1.12 | 1.20 | 1.26 | 1.30 | 1.31 |
Potential benefits of adding an MAI strategy
The above analysis demonstrates that there are benefits for reducing both traditional fixed income and equity exposure and replacing them with MAI. Reducing the allocation to fixed income and replacing it with MAI strategies increases the income return and reducing the allocation to equity reduces the overall portfolio risk. In both instances, we see an increase in the total return achieved by the portfolio. So, the last simulation below shows the effect of reducing proportional amounts of both equity and fixed income at the same time.
Based on Annualized Returns
| 0% MAI Con. |
20% MAI Con. |
40% MAI Con. |
60% MAI Con. |
80% MAI Con. |
100% MAI Con. |
|
|---|---|---|---|---|---|---|
| Total Return | 6.30% | 6.38% | 6.46% | 6.54% | 6.62% | 6.70% |
| Price Return | 3.45% | 2.69% | 1.92% | 1.16% | 0.40% | -0.37% |
| Income Return | 2.76% | 3.62% | 4.49% | 5.35% | 6.22% | 7.08% |
| Standard Deviation | 5.39% | 4.93% | 4.55% | 4.27% | 4.11% | 4.09% |
| Sharpe Ratio | 0.85 | 0.95 | 1.04 | 1.13 | 1.19 | 1.22 |
So, there you have it. Depending on the goals desired, such as increased income, reduced risk or more efficient return, adding MAI to a well-diversified portfolio can take several forms. At just a 5% exposure, income and total return increase with the potential to dampen overall portfolio risk. The benefits accumulate with an increasing exposure. However, to ensure the portfolio remains well-diversified, let’s not go overboard!
And the answer to our third question, do investors even need traditional fixed income such as bonds anymore, is yes. You still need bonds. We believe there is no better asset class to offer capital preservation, consistency of payments, income stability and the potential for tax benefits.
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