The Income Investor's Playbook: Strategies for a Diversified, Yield-Enhanced Portfolio

Thank you to Peter Warken, CFA and his team at DWS Group for their collaboration on this article.

In the ever-evolving world of financial markets, the quest for high and stable investment income is a key priority for many investors. With market dynamics constantly shifting, building robust portfolios to effectively navigate market crosscurrents over the long run remains a challenge. This case study offers a beacon of guidance for income-seeking investors - a new playbook to enhance portfolio yields without compromising portfolio diversification.

?

Setting the stage: The income-seeking investor

The universe of potential investments is vast: equity, bond and alternative investments offer distinct risk-return characteristics. To understand how to combine these opportunities and risks, the global market portfolio - a market-cap weighted allocation of the overall financial market - can serve as a starting point for asset allocators.

However, the allocation of the global market portfolio is not optimal for every investor. It does not explicitly reflect the objective of high and stable income. But how to strike a balance between chasing income and maintaining a diversified portfolio? To translate these preferences into an actionable asset allocation, the global market portfolio is tilted towards income while targeting a similar risk profile and limiting the active risk.

?

Income opportunities within each asset class

The following opportunities for income-seeking investors within each asset class are observed:

• Equities: The long-term expected return can be decomposed in three fundamental drivers: income, growth and valuation. In some regions, the %-share of the income pillar is significant. Switching from a market value-weighted to a high dividend-yielding approach can further increase the yield of the portfolio. However, a full switch leads to active risk: factor rotation or extended periods of outperformance of other styles can leave you behind longer than you can last. Thus, a prudent, balanced approach is required.
• Fixed Income: the role of bonds has significantly changed during the last quarters. With global yields at multi-decade highs, bonds have income to offer again – without the need of losing too much credit quality or going too far out in maturities. Thus, it is natural to turn the attention to corporate bonds to achieve the desired income tilt.
• Alternatives: Some alternative investments should, by design, deliver regular income streams. For example, private debt and infrastructure have historically exhibited this feature. Thus, it is obvious to think of them as part of an income portfolio, as long as investors understand the peculiarities of the private markets.

Optimize across asset classes: Bringing it all together

While it is important to identify opportunities within asset classes, it is even more crucial to have a framework in place to make use of these ideas from a holistic portfolio perspective. GRIP, the proprietary optimization approach of DWS that leverages long-term capital market assumptions, is designed to create allocations that are truly diversified and that are aligned with clients’ specific investment needs. Using GRIP in this case study yields encouraging results: the current market regime offers opportunities for income-seeking investors at reasonable risks.

In this analysis, the allocation to equities decreases, alternatives increase, and fixed income remains almost unchanged compared to the global market portfolio. Within equities a partial shift to high dividend yielding stocks takes place. Within fixed income, a focus on investment grade credit and some risk-controlled shifts to high yield and emerging market debt are observed. In the alternative segment, private debt and infrastructure are the preferred sub-asset classes.

The most pronounced shift is observed for credit. Not only on a standalone basis, but also compared to equities, the new yield environment makes the case for a shift to corporate bonds. A simplified argumentation: most equities in the Eurozone offer less dividend yield than a broad allocation to EUR investment grade corporate bonds. It goes without saying that yield-to-volatility ratios point even stronger in the direction of credit.

The road ahead for income-seeking investors

Targeted allocation decisions can support investors to better achieve their objectives. This study showed that income-seeking investors can benefit from rather simple tilts to accomplish their investment goals without materially altering the risk of their portfolio. By leveraging the global market portfolio and portfolio construction tools, tailored solutions can be designed that meet the demands of investors – beyond this case study.

?