This is a sponsored article from Wellington Management.

Income investing is a tough game these days. Though beginning to rise in some markets, bond yields remain low. Higher-risk bond sectors offer higher yields, yet tight credit spreads mean scant reward for taking on extra risk. In equities, dividend yields have generally held up well but market valuations seem stretched, heightening the risk of significant drawdowns in a bear market. Multi-asset investing offers the potential for less portfolio volatility through asset-class diversification, but carries its own set of risks, such as crowding into illiquid high-yield and niche credit sectors, limited flexibility to adapt the portfolio through cycles, and a narrow range of risk-management techniques. Continued strong demand for income has exacerbated these trends by driving capital into increasingly expensive and often illiquid yield-bearing assets.

Given these challenges, how can an investor earn consistent and attractive levels of income, while retaining significant total-return potential and limiting exposure to equity-market risk? We think the answer can be boiled down to four Ds.

Diversification across economic regimes can mitigate lopsided exposures to particular macro environments

Economic and market environments can vary over time. Maintaining exposure to sets of assets that behave differently in different market conditions can help cushion the income stream and portfolio capital from adverse regime shifts. To avoid an overreliance on high-yield credit securities for income, limits on exposure to such sectors may be prudent, helping defend capital from major credit events and ensuring that the portfolio maintains enough liquidity to let it be truly dynamic as markets change.

Differentiated implementation by type of exposure can tailor execution using a range of analytic lenses

Passive market exposures work well in the early years of an investment cycle; however, they might be inefficient and highly concentrated, which could increase unintended risk as the cycle matures. Factor-based exposure to global equity and fixed income markets, along with access to specialised investment teams, may improve overall efficiency and return experience. Through risk budgeting, a portfolio’s managers may be able to target returns with substantially less volatility than equity markets. Using a systematic investment process to implement positions allows a manager to draw on a broad mix of insights from fundamental, quant, macro, and technical analysts to implement equity income exposures with below-broad market volatility, while selecting global fixed income holdings to target sustainable income with robust levels of credit quality. A manager should also be able to take opportunistic exposures where upside trades present themselves – by investing in sectors perceived to offer good value, for example, or by taking advantage of shorter-term market pricing to mitigate the downside when hedges appear cheap.

Dynamic asset allocation raises the odds of meeting targeted outcomes as market conditions shift

Capital markets are constantly evolving, creating opportunities and risks. We think it is possible to tilt away from risks to generate more return and limit drawdowns by adjusting asset allocation as the economic environment evolves – increasing exposure to growth assets such as equities when the backdrop remains supportive of growth and boosting weak-growth exposures like government bonds when the environment appears set to deteriorate. These kinds of adjustments can lead to more consistent investment results over time, helping a strategy achieve target levels of income and total return both when economic times are strong and in downturns.

Disciplined risk management may preserve capital in down markets using several cross-disciplinary tools

Market downturns can be hard to recover from, but we think multi-layered risk management can mitigate downside risk. One such layer is structural diversification – for example, duration in fixed income holdings can offset losses in equities during risk-off episodes. Another layer is dynamic volatility management, which can help stabilise portfolio risk levels. Drawdown filters can also mitigate downside by automatically reducing exposure before prolonged drawdowns become extreme. Yet another layer is opportunistic risk hedging — mitigating risk-model vulnerabilities using discretionary hedges against key market risks, with the degree of hedging varying across time and hedge costs. Using this tool, a strategy may be able to preserve capital and more rapidly rebuild performance than other portfolios that remain fully invested during a damaging market crisis.

Through these four Ds, we think it is possible to earn attractive levels of income and capture significant total-return potential, with substantially less volatility than equity markets.

For further conversations on this topic, please contact the author at [email protected].

This is a sponsored article from Wellington Management.