July 7, 2010

Thinking Outside the "Income" Box

It's official (it has been for a long time actually): investors' tolerance for risk has been shaken. Need evidence? Investors continue to pour billions of dollars into taxable and tax-exempt bond funds, with $74 billion and $14 billion of net inflows respectively in the first quarter of 2010 alone, according to the April 2010 Morningstar Direct Fund Flows Update. Keep in mind that these sums are on the heels of record-breaking net inflows in 2009 of $284 billion and $72 billion respectively. Of course, while this migration is accentuated by late-to-the-party performance chasers, there has been a marked rise in investor demand for income generating portfolios and the relative stability they provide.

For those investors that have turned to fixed income, the question becomes: How to handle interest rate risk? As a due diligence consultant that meets regularly with asset managers, this has been a popular topic of discussion. While the managers we speak with diverge in their opinions of when rates will increase, they are unanimous in their prediction that following a period of lackluster growth and low inflation, rates will, must, have to...rise. Unprecedented economic stimulus, ballooning government spending and ever-expanding federal debt leave few tools to rein in future fiscal situations, with the likely result of inflating our way out of our overwhelming debt burden. Coupling these factors together leads many of us to believe that the 20+ year secular decline in interest rates has come to an end. It is not a question of if, but when, interest rates will rise, and by how much over the yield curves.

Similarly, the fixed-income credit spread picture offers little relief for investors. In 2009, non-Treasury fixed income securities experienced record-setting excess returns, with everything from Agencies (+2.9% outperformance) to U.S. Corporate High Yield Bonds (+59.5% outperformance) vastly outpacing Treasuries, according to BlackRock's Barclays Indexes. The dramatic risk-trade rally of 2009 and its continuation into 2010 left spread-sector yields at or near historic lows, as of April 30 in Barclays Capital Live Database. This puts investors between a rock and a hard place, since money markets are essentially yielding 0% and there is little room for further spread compression.

For many advisors who are concerned with the potential for rising rates, many are shortening the durations of their clients' bond portfolios and focusing on analyzing the quality of the underlying credits. Others have turned their attention to equity dividend managers to satisfy their clients' demands for high current income. However, not all dividend managers are created equal nor do they share the same investment objective. Some emphasize dividend growth rates while others seek high portfolio yields as the first and only priority. The problem with this solution for certain investors is that the all-equity portfolio is still vulnerable to violent swings in the stock market, and to achieve a yield above 4%, portfolio concentration and a limited stock universe can be problematic.

In our view, little attention has been paid to more opportunistic, specialty managers that cross asset class boundaries to meet high income mandates. One such example is the Forward Uniplan Advisors--High Income Total Return SMA strategy. The manager combines dividend paying common stocks, real estate investment trusts (REITs), master limited partnerships (MLPs), convertible bonds and preferred stocks into one portfolio to provide clients with high income (typically 5%+), less-correlated, and potential equity-like upside returns. The strategy's U.S. equity correlation, benchmarked against the Russell 3000 Index, is typically 0.75, while the U.S. fixed income correlation, benchmarked against the Barclays Aggregate Bond Index is +/- 0.10.

The portfolio's allocation to each asset bucket (that is stocks, REITs, MLPs, convertibles/preferreds) will dynamically shift over time as relative values gyrate. In short, as one bucket becomes overvalued (as yield decreases), capital is allocated to the other, higher yielding assets. This has helped the portfolio of 30 to 50 securities maintain a consistently high dividend yield, while providing a margin of price risk protection. Of course, investors need to be comfortable with the distinct risks associated with the real estate market and the liquidity constraints of MLPs. The roots of this strategy have evolved over the past 25 years from the firm's beginnings as a quantitative balanced manager using similar spread tools to measure the relative value between the equity and debt of a single corporation.

There are a growing number of these types of flexible strategies from reputable asset managers in a variety of asset classes. For instance, we have covered certain non-traditional mutual funds in this column in the past, and there are also other real return and inflation hedging portfolios that have come to market. Read "Commodities Help Diversify Portfolios," or "Increased Opportunities in Emerging Markets" and "A Case for Alternatives."

The keys to successfully adding these managed products to a client's portfolio are to understand the harmonics of the total portfolio and how these managers impact the risk-return characteristics for the client.

Though advisors are faced with the daunting task of wading through a supersaturated market of investment products, the silver lining is that now there are many different tools available to achieve clients' investment objectives, if adequate resources are devoted to manager search, evaluation and selection. Instead of relying on conventional wisdom and traditional style-box constrained solutions, advisors are able solve each client's unique portfolio construction challenges, add measurable value, and further differentiate themselves in the process.

J. Gibson Watson III is president and CEO of Denver-based Prima Capital, which conducts objective research and due diligence on SMAs, mutual funds, ETFs and alternatives.

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