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A risk-based approach to building portfolios
- With the search for yield only gaining momentum, investors have been forced to choose between accepting lower income and expanding into higher-risk asset classes.
- Expanding the investable universe can help achieve that stable higher income potential while providing greater confidence that risk is distributed across asset classes.
- Our risk-first approach to multi-asset portfolio construction introduces new asset classes and more complexity, but this also increases the opportunity to build more diversified portfolios.
To achieve the income and returns needed in today’s low-yield environment, investors must take a more robust approach to generating income.
Investors are seeking two main things from income portfolios today: stable income with reduced volatility. However, it is increasingly difficult to construct portfolios that can meet both of those goals.
Investors have been forced to choose
With the search for yield only gaining momentum, investors have been forced to choose between accepting lower income or expanding into higher risk asset classes. (Figure 1) This makes the capital appreciation component of a portfolio even more important in order to shield excessive volatility and drawdown and keep pace with inflation.
As a result, we must introduce new sources, new asset classes, more complexity and potentially more risk — but this also increases the opportunity to build more diversified portfolios.
Diversifying by expanding the investable universe is one way to increase durable income potential. With higher volatility impossible to avoid, it is important that investors understand which risks they are taking on and how this may help to achieve their portfolio goals.
Thoughtful portfolio construction involves balancing income and risk
We create diversified income portfolios by first examining what drives the income and risk in each asset class. With this in mind, we have identified three broad-based risk factors that are central to income investing:
Interest rate risk. Interest rate sensitive asset classes have historically been used to generate income and provide diversification, primarily through mitigating equity risk. These asset classes typically rise in value as interest rates fall.
Credit risk. The risk and reward of these asset classes are driven by default risk. They deliver higher income, but are also more prone to volatility and have a higher correlation to equities. These investments tend to do well when the economy is strengthening.
Equity risk. These asset classes have the highest correlation to movements in the stock market, otherwise known as equity beta. Like the credit group, performance is based on the financial condition of the companies. This grouping introduces the highest level of portfolio volatility, so being selective and deliberate is key.
It’s best to think about these risks in combination, rather than focusing on any one category in isolation. (Figure 2) For example, the equity and credit categories tend to be more highly correlated, whereas the interest rate group tends to diversify the other two.
Portfolios should be diversified between categories and within each category, such as between high yield corporates and high yield municipals. And introducing private credit strategies, such as direct lending, adds exposure beyond traditional fixed income and may reduce the volatility profile during especially troubling periods.
Flipping the model: Start with risk factor allocation
Key to our investment philosophy and process is the idea that investors are compensated for owning risks, not asset classes. Every asset class has exposure, in varying degrees, to all three broad-based risk factors. Idiosyncratic risk, including manager skill, also drives returns. If these risk drivers are not carefully considered, a portfolio could end up with significantly more exposure to equity, credit or rate risk than an investor intended.
We believe that the portfolio construction process should reflect these elements:
- Understand the risk factors that contribute to the performance of each asset class.
- Determine which risk factors to own based on how the market is currently rewarding those risks.
- Consider each investor’s unique objectives and constraints.
- Select specific investments that would be the most efficient way to own those risks. Asset allocation becomes a by-product of risk allocation.
Some investors consider preferreds to be more like an equity instrument, while others consider them to be more like fixed income. While preferred yields may be similar to core fixed income, equity risk accounts for 93% of their total risk.
Monitor the changing environment
The risk and return attributes of each asset class are constantly shifting within the three risk categories, influenced by economic developments. We determine key investment themes based on market conditions and forecast how those themes may affect portfolio risks and opportunities. Right now, we see the following major forces shaping the markets:
- Fiscal and monetary stimulus responses continue to be key drivers of near-term sentiment and returns, boosting opportunities for strategies that allocate across high quality credit investments.
- Higher inflation expectations typically put upward pressure on rates. As a result, allocations to asset classes such as senior loans and direct lending would be more favorable than those that are more rate sensitive.
- Portfolio ballasts may not be able to rely on historical correlations, making a case for more defensive asset classes or more creative ways to address portfolio volatility.
Putting it all together
In constructing an overall portfolio, investors should determine where they fall along the spectrum of stable income and reduced volatility priorities.
The hypothetical portfolios shown in Figure 4 begin on the left with mainly interest rate risk and lower volatility. They gradually add credit and equity risk to increase the yield potential, as well as volatility.
Enhancing income through diversification
We understand that investing for income has grown more complicated over the years in the face of declining overall yields and increasing volatility. Meeting portfolio goals now requires a new way of thinking.
In response, active managers are taking a more nuanced view by expanding the universe and diversifying through the lens of what’s driving risk and income. This portfolio construction process primarily allocates to risks rather than to asset classes.
Investments must be added thoughtfully, with investors understanding which underlying risk drivers have the most influence on the portfolio. And we don’t think this is a time for investors to go it alone. Working with an experienced and skilled financial professional and professional asset managers to develop truly diversified income portfolios is more important today than ever.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. For term definitions and index descriptions, please access the glossary on nuveen.com. Please note, it is not possible to invest directly in an index.
A word on risk
Equity investments are subject to market risk, active management risk, and growth stock risk; dividends are not guaranteed. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. These risks are magnified in emerging markets. The use of derivatives involves additional risk and transaction costs.
Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, tax risk, political and economic risk, derivatives risk, income risk, and other investment company risk. As interest rates rise, bond prices fall. Credit risk refers to an issuer’s ability to make interest payments when due. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risk. Foreign investments involve additional risks as noted above.
Socially responsible investments are subject to social criteria risk, namely the risk that because social criteria exclude securities of certain issuers for non-financial reasons, investors may forgo some market opportunities available to those that don’t use these criteria. Investors should be aware that alternative investments including private equity and private debt are speculative, subject to substantial risks including the risks associated with limited liquidity, the use of leverage, short sales and concentrated investments and may involve complex tax structures and investment strategies.
Nuveen provides investment advisory services through its investment specialists.