Income portfolios set to grow in popularity

This article is part of
Discretionary Fund Management - October 2014

Investing for income is hardly new.

The Hebrew Bible set out strict rules for income-producing land transactions a very long time before the birth of Neil Woodford or the creation of the FCA.

Income portfolios are likely to become even more popular over the next few years as more retirees eschew annuities in favour of a managed portfolio.

Yet in spite of this long history and rising popularity, many of the techniques used to build and manage multi-asset income portfolios are unfit for purpose. Consequently, clients are often left feeling short-changed. The poor quality of many existing offerings not only impacts the client, but also the business of the adviser, as disappointment among clients creates regulatory risk.

The greatest weakness in existing income portfolios are the capital market assumptions (CMAs) used to create them. CMAs lie at the heart of all portfolios that are not simply managed in relation to a benchmark.

High-quality CMAs will tend to create more robust strategic asset allocation (SAA) models, which in turn should generate superior risk-adjusted returns for clients. In contrast, poor quality CMAs are likely to produce sub-optimal outcomes.

At present, these CMAs are most often supplied by a third-party, risk-profiling tool or specialist asset management business. These businesses tend to create generic total return portfolios that typically do not distinguish between the income-focused sub-classes of each asset and those of the main benchmark index.

Consequently, there is an inevitable mismatch between the CMAs used to create the portfolio and the funds used to populate that portfolio. This mismatch will impact the risk profile of the portfolio. In order to build a realistic and deliverable income portfolio, it is essential to create a bespoke set of CMAs for income portfolios that take these issues into consideration.

The basis of the optimisation process is another key weakness in traditional income portfolios. Most income portfolios use a traditional mean-variance model with the simple addition of an absolute income target to create the SAA of a portfolio. Setting aside the fact this form of optimiser is susceptible to significant ‘tail’ risk, the most pertinent problem for income investors is that the yield indicated by this optimisation process is historic and may not represent a sustainable future flow of income.

The simplest response would be to stick with traditional portfolio construction methods and simply buy income units. While this approach will reduce the mismatch between the theory and practice of managing these portfolios, it is likely to deliver a very low level of income in the current environment.

Even if this simplistic approach is adopted, the problems with traditional income portfolios extend to the execution and management of the portfolios. While most platforms are able to distribute the natural income generated by the portfolio, some do not segregate this income from the main portfolio before payment. This means that when the portfolio is rebalanced, the income waiting to be paid will be sucked back into the portfolio and reinvested.