ETF Trends
ETF Trends

By Rusty Vanneman, CFA and Josh Jenkins, CFA

At the mid-year checkpoint, income-oriented ETF portfolios are ripping it up. With a tailwind of lower interest rates and tighter credit spreads, most income-oriented asset classes have handily outperformed the broad market indices.

The risk for many investors now is the desire to chase recent returns. Chasing performance is never a healthy investment strategy. With that in mind, which investors are best suited for high-income strategies? Do they understand the risks involved? When do income strategies perform best? When do they perform worst? How should income strategies be benchmarked? Lastly, what’s our outlook?

Who Are Income Strategies Best Suited For?

Shifting demographic trends in the U.S. have created an opportunity for the investment industry. Based on the most recent census data, nearly 40% of Americans are in, or will soon enter, the distribution phases of their investment careers. This development will require adaptation by investment managers as investor goals shift. Young investors enter the workforce and progress through their careers with a typical focus on accumulation, building the wealth that will one day carry them through retirement. As retirement approaches, investor goals typically transition from accumulation to distribution. Here, the focus shifts to generating an income stream to sustain life after retirement. The investment industry will be forced to pivot in order to satisfy increasing demand from income-focused investors.

Recent Performance

There are some income strategies already available in the marketplace today, and their performance so far this year has been impressive. The typical multi-asset income portfolio is up 5% to 9% through the end of the second quarter, while many globally diversified, balanced portfolios are only up half as much.

For example, here’s a representative income portfolio that targets a net yield of 3%+ and its year-to-date performance through June 30:

Several market developments have contributed to this strong relative performance. Interest rates have fallen substantially, providing a strong tailwind to interest-rate-sensitive assets. Brexit fears have fostered the belief that central banks globally will keep benchmark interest rates lower longer, a positive for emerging market assets. Finally, the recovery of oil prices has led to a resurgence in high-yield bonds. Many asset classes affected by these developments, including those above, are staples within many income portfolios.

Beware of Risks

Investors generally associate income strategies with lower overall risk. Depending on the nature of the specific strategy, however, this assumption can prove to be unfounded. For example, income strategies are sensitive to movements in interest rates. After all, if Treasury bonds provided sufficient yield, investors would have little need to take any risk in their portfolios. They could simply own and mature a portfolio of risk-free Treasury bonds. Unfortunately, Treasury bonds don’t provide a sufficient yield. In fact, what they offer is far from it (the 10-year Treasury yield hit an all-time low recently). A consequence of these low yields is a push from investors into higher-risk assets to satisfy their income needs.

The typical income strategy diversifies across asset classes. It provides exposure to traditional dividend-oriented stocks and investment-grade bonds, as well as some non-traditional asset classes, including: high-yield bonds, emerging market bonds, real estate investment trusts (REITs), preferred stocks, and master limited partnerships. These portfolios certainly provide exposure to risky assets.

SEE MORE: Is Your Minimum Volatility ETF a Crowded Trade?

At CLS, we prefer to look at risk relative to a broadly diversified equity portfolio. We find our investors are typically most comfortable using equity benchmarks to interpret portfolio results. This approach keeps our investors’ interpretations of risk and return consistent. Applying this risk framework to the income space, we have found the typical strategy carries 65%-85% of the risk of a broadly diversified equity portfolio (and about 3x the risk of a typical multi-sector bond fund). This level of risk would be consistent with a moderately aggressive investor. Not necessarily a low-risk approach but still appropriate for an investor with sufficient risk tolerance.

When Income Strategies Do Best; When They Don’t

Unfortunately, no investment approach works all the time, and income strategies are no different. Understanding what environment leads to strong vs. weak results is of critical importance to all investors. 2016 has provided a good example of when income strategies can be expected to exhibit strong relative performance. Through the second quarter, the yield on the 10-year Treasury fell by 80 basis points (bond prices move inversely with yields). This dramatic move has been a major tailwind for income strategies, though other developments, including the recovery in commodity prices, have contributed positively.

The environment that would most likely cause income strategies to underperform would correspond with rapidly rising interest rates. No surprise here; it is the opposite of the scenario that has led to superior results. As yields rise, the prices of bonds fall. In many cases, other asset classes that typically deliver a high level of income also fall. The risky asset now looks less attractive as the risk-free asset becomes more competitive from an income standpoint.

Benchmark

Unlike many funds and strategies available in the marketplace that adhere to an asset-class-specific mandate, income strategies adhere to an investment outcome. This inherently makes them asset allocation portfolios. A strong benefit is a wider set of asset classes available for the manager to take advantage, but that can make selecting an appropriate benchmark more difficult.

An appropriate benchmark should be representative of the manager’s opportunity set. This helps measure and manage active asset allocation decisions. In this circumstance, a blended benchmark is generally the best option. The benchmark should include traditional asset classes, such as global, dividend-oriented stocks and investment-grade bonds. Non-traditional asset classes would also be suitable, including high-yield bonds, preferred stock, master limited partnerships (MLPs), REITs, and emerging market bonds.

SEE MORE: Is Your Bond Portfolio Riskier Than You Think?

Outlook

Despite the historically low level of interest rates, there is still reason to believe they will not spike in the near term. Nominal economic growth is expected to remain low. The amount of developed international government debt trading at a negative yield is measured in the trillions. Lastly, it is unlikely that we have seen the end of volatility in the equity market.

Summary

The demographic shift in the U.S. has created higher demand for strategies focused on the distribution phase rather than the accumulation phase of an investor’s life. Strategies exist today to take advantage of this shift, and they have been performing extremely well. Challenges still exist however, including matching investors’ risk exposures with their tolerances, educating them on the market conditions that lead to outperformance vs. underperformance, and establishing an appropriate benchmark to assess active management decisions.

Rusty Vanneman is the Chief Investment Officer at CLS Investments, a participant in the ETF Strategist Channel.

Disclosure Information: 

This information is prepared for general information only. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such.  All opinions expressed herein are subject to change without notice. 2207-CLS-7/28/2016