To do that successfully, managers need a clear set of strategic beliefs about how different assets perform, and which risks will be rewarded under different market conditions. For instance, some believe that, over time, investors earn higher returns by investing in credit markets than by investing in government bonds, and so are rewarded for accepting the higher risks of issuer default that come with credit.
Managers also need a clear understanding of the drivers of risk. For instance, investors would typically think of a government bond issued by the US Treasury as lower-risk and less volatile than a leveraged loan issued by a sub-investment grade company. However, the prices of longer-dated bonds can move sharply in response to changes in expectations of the interest rate outlook. So the prices of longer-duration 10-year treasuries have historically been more volatile than “risky” shorter-term leveraged loans. That is because for leveraged loans the majority of volatility comes from credit risk, but for treasuries the volatility comes from duration. It is also important to understand the factor risks that are typically embedded in manager portfolios. For instance, high-dividend equity portfolios typically have a bias towards larger cap companies and to value as a factor. Managers want to ensure that any biases in their portfolios are consistent with their strategic beliefs. Research shows that good-value stocks will outperform over time, and so managers are likely to favour a tilt to value in their portfolios. By contrast, some believe that smaller-cap stocks outperform over time, so they will typically aim to moderate or neutralise a tilt to large cap. Balancing the different types of risk and reward is key to successful portfolio construction and to achieving their responsible income objective.
Because yields are changing all the time as market prices move, dynamic management is particularly important for multi-asset income portfolios. For example, over recent years we have seen very significant falls both in leading government bond yields and in the higher quality parts of the credit markets. These changes mean managers need to keep adjusting their portfolio allocations as they continue to seek alternative sources of yield and better ways to diversify portfolio risk. I believe it is important to stay widely diversified and keep aware of total return. We are seeing a number of esoteric but unproven income strategies – for instance new products based on aircraft and ship leasing. Some investors rotated out of investment grade and into high-yield credit last year, only to find the high-yield sector hit hard by falling oil prices and a severe setback for the corporate bonds of oil exploration and production companies. Some prefer a wider spread of strategies across credit and high-dividend equities. Currently, managers can earn a 4 per cent yield in some European equities, and they are looking to protect some of the downside risk by implementing a put option strategy. Credit markets are cyclical and so managers manage dynamically both their overall exposure to credit and their exposures to different underlying credit strategies. In particular, by altering the balance between fixed and floating rate credit strategies, managers can adjust their portfolios’ sensitivity to potential changes in the interest-rate environment.
