Efficient Income Investing

December 21, 2012

The Origins And Evolution Of Delta-One

There is comparatively little guidance on how to build an efficient income portfolio. Traditional portfolio optimisation research has typically focused on total return strategies, which combine price and income returns. While total return portfolios do, of course, generate income, they may not be appropriate for investors who wish to consume portfolio income while not liquidating principal.

In this article, we explore the concept of efficient income investing by introducing a simple new utility function used to determine the optimal income return portfolio allocation. The differences between efficient income return portfolios and total return portfolios will be reviewed and the impact of taxes will be briefly be touched on. Our results suggest that investors with an income focus are better served by portfolios that are specifically constructed to generate income, as opposed to those constructed to maximise risk-adjusted total return.

The Need For Income Investing

Demography and volatile markets have increased demand for income-oriented investments. Investors in or approaching retirement seek products that will produce enough current income to help support their consumption needs. Additionally, many investors remain comparatively risk-averse, given their experience of the 2008 credit crisis and the continued fear that the ever-unfolding European debt crisis will metastasise into something similar.

While the demand may be strong, the type of product mix best suited to these investors isn’t well defined. Indeed, generating consistent income from a portfolio is no easy task. A volatile market and low-to-negative real interest rates combine to make today an especially difficult environment for yield-focused investors. While it is our view that there is no unique solution—a mix of guaranteed and capital market assets may be best—we do believe that a multi-asset class/multi-strategy income oriented fund is a necessary component of most retirees’ plans.

Although such an income-focused strategy is desirable, there has up to now been little focus on how to implement it in an efficient and comprehensive way. Although a traditional mean-variance efficient portfolio will produce income (indeed, this is nearly all it will produce at sufficiently conservative levels), it is not focused on income as an objective, implying that we should look at alternative ways of constructing an income-oriented portfolio.

The utility function we introduce below trades between income and price return and income covariance and price covariance as a function of investor preference. The differences between efficient income return portfolios and total return portfolios will be reviewed, and we will provide a brief justification for income return over total return in the presence of taxes. This approach results in portfolios that are materially different than those constructed using a total return approach.

Income Versus Total Return

One critique of building a portfolio based on income is that it will result in portfolios that are inefficient when viewed from a total return framework. While this critique has some merit, it assumes that the investor is indifferent to the form in which returns are realized.. The income investor places more value on current income and might even be willing to pay higher taxes on that income in order to receive a relatively stable stream of payments. This isn’t a radical concept and can be defended on traditional asset pricing grounds (see Cochrane 2001).

However, income investors, like their total return counterparts, have a range of preferences. Specifically, they have varying preferences with respect to the trade-off among income, volatility of income, price return and volatility of price return. It is conceivable, for example, that an investor with no need to draw on principal may be comfortable with accepting significant price volatility for relatively high and stable income.

An example of an investment that could be viewed differently, based on the risk preferences of an investor is the iShares S&P US Preferred Stock Index Fund (ticker PFF). The historical price of PFF since inception and the rolling average six-month dividend are shown in Figure 1. As the reader can see from Figure 1, while the historical price fell from approximately $50 to $15 from the inception date to March 2009 (a decline of 70%) the historical monthly dividend has been relatively constant, averaging $.232 per month, which is $2.784 per year.

Figure 1
For a larger view, please click on the image above.

PFF has exhibited significant price risk but relatively little income risk. It would therefore be an attractive investment for an investor focused on income but not total return. While some may argue that this form of preference modeling is somewhat irrational, it is definitely a preference shared among many investors, especially retirees. In fact, we would argue that it can be defended on economic as well as behavioural grounds. Since this preference cannot be captured by focusing on total return alone, a new measure of efficiency is required to build a portfolio for an income-focused investor.

 

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