Efficient Income Investing

December 21, 2012

A Word On Tax Efficiency

Although we have not incorporated taxes into our analysis, a word on tax efficiency is in order. A common critique of income-oriented investing is that it is tax-inefficient because income is taxed immediately, while capital return can be deferred. While this is important to note, potential tax liability becomes increasingly less important to an investor as the preference for consistent income increases. To illustrate this effect we use the following power utility function:

Where:
C = income
γ = income risk aversion level
t = tax income rate

In Figure 10 we graph two utility curves, one assuming no taxes, the other assuming a 35 percent tax rate. We also show them at different levels of risk aversion, 2.5 (generally considered to be a “moderate” level of risk aversion and the comparatively high 5. Given that this sort of product is usually aimed at very risk-averse investors, we believe that 5 is reasonable.

Figure 10
For a larger view, please click on the image above.

Panels A and B in Figure 10 demonstrate that as the level of income increases, the post-tax utility and the pre-tax utility converge; albeit very slowly for a moderate risk investor. As risk aversion goes up, however, we see the two converge rapidly as the tax cost is outweighed by the benefit of income’s surety. It is trivial to show that as tax liability drops and risk aversion increases, the utility values converge with increasing rapidity. The economic take-away here may be that less wealthy investors in comparatively low income brackets with relatively little risk capacity (which we define as being embedded in the risk aversion coefficient) will derive the greatest utility from an income-oriented product.

Conclusions

As more investors approach retirement, they will increasingly seek solutions to help them generate income. Additionally, increasing levels of risk aversion due both to the life stage of these investors and concerns about increased market volatility are pushing them toward less risky options. Despite the potential appeal of income-focused products, few diversified options currently exist to meet this objective. This is likely due to the industry’s focus on total return.

This paper introduced a new framework to determine how to build an asset allocation with an income focus. Portfolios focused on income are likely use asset classes that may be ignored in traditional optimisations, such as preferred stock, long-dated bonds, and emerging market bonds. Income-efficient portfolios may have asset allocations that vary considerably from traditional mean variance portfolios (focused on total returns) and therefore investors seeking income are likely best served using approaches or portfolios built with this goal in mind.

Endnotes And References

  1. Based on Equation 2, which is introduced later in the paper
  2. This is based on 24 month average yield of long-term Treasury bonds, i.e., uses a long-term proxy as the risk-free rate, versus something shorter term in nature (e.g., 3 month Treasury bills)
  • Black, Fischer, and Robert Litterman. (1992). “Global Portfolio Optimization.” Financial Analysts Journal, September/October, 28-43.
  • Cochrane, John H. 2001. Asset Pricing. Princeton University Press
  • Chopra, V. K. and W. T. Ziemba. (1993). “The Effect of Errors in Means, Variances, and Covariances on Optimal Portfolio Choice”, Journal of Portfolio Management, Winter, 6–11.
  • Idzorek, Thomas, Mike Barad, and Steve Meier. (2007). “Global Commercial Real Estate.” The Journal of Portfolio Management. Special Real Estate Issue, 37 – 53.
  • Sharpe, William F. (1974). “Imputing Expected Security Returns from Portfolio Composition.” Journal of Financial and Quantitative Analysis, June, 463-472.

 

Find your next ETF

Reset All