All investors need a structured framework for making investment decisions. This is particularly so for those seeking to generate a sustainable level of income now and into the future.
Current investment conditions are characterised by ultra-low short-term interest rates, rising longer-term interest rates and stretched sharemarket valuations, particularly in the US and at home here in New Zealand. The risks of higher inflation in the years ahead have also risen given accommodative central bank policy settings and high levels of government spending. Overall, this signifies a challenging future return environment.
Such an environment needs to be navigated with an appropriate investment framework that not only helps investors get through the current situation but also makes the most of future opportunities as they arise. Critically the framework should position portfolios to generate a stable and sustainable level of income over the longer term.
In this post I look at the four main pillars of an investment framework to deliver a stable and sustainable level of income over time. In doing so, it challenges some of the conventional wisdoms underpinning the management of traditional portfolios.
1. Goal orientated approach
The primary objective should focus on generating income with moderate levels of portfolio volatility. This is a different mindset from how a traditional portfolio is managed which aims to maximise total returns for a given level of risk. Pursuing a traditional approach and portfolio may also lead to a higher level of variability in income from year to year compared to a goal orientated approach.
By focusing on income as the primary goal, different decisions and trade-offs can be considered compared to managing a traditional portfolio. For example, a greater allocation to higher yielding sectors of the global equity market may be more appropriate for an income orientated portfolio. Although these sectors may at times produce a lower total return than investment into the broader equity market, such allocations are consistent with an income orientated objective.
If the goal is to generate income, then a key portfolio risk to measure is the volatility of income from year to year. It means there should be a focus on managing the variability of income generated from the portfolio. This is addition to managing the volatility of the total portfolio – which is the volatility of capital invested to generate the income.
2. Be active
Security selection should be active from the perspective of identifying companies that can maintain a sustainable and growing dividend over time. This is because passively selecting a bunch of higher yielding securities may not provide the best outcome longer term.
Research suggests that investing in those companies that are steadily growing their dividends is likely to provide better outcomes. Therefore, it is important not to simply chase yields as often there are risks associated with a security offering a higher current yield. Here, continued analysis of the underlying business case and asset quality is required to gain comfort that the income generated can be maintained and capital will not be lost.
Dynamic Asset Allocation (DAA) is another tool in the kit to assist with generating a stable and sustainable level of income. Although DAA is primarily implemented to manage portfolio risks, it can also be employed to take advantage of significant market dislocations to boost investment outcomes over time.
3. Diversify income source
Diversification in the context of managing an income generating portfolio emphasises diversifying sources of income and considering the interplay of risks within these allocations.
Diversifying sources of income involves investing in a wider range of asset classes in a more equally weighted basis than a traditional portfolio. It includes investments such as credit, longer and short dated fixed income securities, inflation linked securities, higher yielding asset classes and real assets such as property and infrastructure.
Diversification from the interplay of risks of these allocations means avoiding an over allocation or reliance on one particular asset class to generate income, for example term deposits. It also involves considering the concentration of risks within an individual sector which forms part of an asset class, such as the gentailer sector within the New Zealand sharemarket. Such risks need to be actively managed.
Lastly, diversification requires a deep understanding of the sources of risk and how they impact on generating a stable level of income. For example, the New Zealand sharemarket being a higher yielding market is more sensitive to movement in longer-term interest rates, so such risk drivers need to be taken into consideration when developing a truly diversified portfolio.
4. Long-term focus
To generate a stable and sustainable income stream, the ability to look through short-term volatility and focus on the quality of underlying assets is paramount in what is anticipated to be a higher interest rate environment. Such an approach, successfully implemented, will likely result in higher levels of income over the full market cycle.
The investment framework outlined above needs to be robust to withstand a full market cycle and avoid large swings in income generated from year to year. It reflects the management of not only real income (after inflation) but also longevity risk (that the strategy delivers a stable and sustainable real income over retirement).
This framework is also consistent with AMP Capital’s active value-add approach, maintaining a longer-term investment horizon, delivering insights and value through research, and implementing transparent and repeatable investment approaches.
This blog post has been prepared to provide general information and does not constitute financial advice in accordance with the Financial Markets Conduct Act 2013. An individual investor should, before making any investment decisions, consider the information available in the relevant Product Disclosure Statement and seek professional advice. While every care has been taken in the preparation of this document, AMP Capital Investors (New Zealand) Limited and the AMP Group (together, 'AMP') make no guarantee that the information supplied is accurate, complete or timely and do not make any warranties or representations in respect of results gained from its use. The information is not intended to infer that current or past returns are indicative of future returns. The views expressed are those of the author and do not necessarily reflect those of AMP. These views are subject to change depending on market conditions and other factors.