Over the last seven years, investors have been challenged to find decent investment income in a low-yield environment. For some, multi-asset income funds are providing at least a partial solution to the drawn-out investment income drought.
As the name implies, these funds use a variety of different investments and strategies to generate yields in the 3% to 6% range. Some invest in a mix of stocks and bonds that stays the same over time, while others tap a broader array of securities and change their allocations to adjust to market conditions. Some employ currency and interest rate hedging strategies, while others do not.
Launched in 2008, the $11 billion BlackRock Multi-Asset Income Fund (BIICX), one of the largest members of the genre, takes a highly active approach that involves a lot of moving parts. Depending on market conditions and his outlook for component asset classes, fund manager Michael Fredericks adjusts allocations among a variety of income-producing investments such as dividend-paying stocks, high-yield bonds, preferred securities, government bonds, floating-rate notes, master limited partnerships and real estate investment trusts. He also hedges with instruments such as currency or interest rate futures contracts when conditions warrant, and may sell covered call options on securities in the portfolio to generate additional income.
Fredericks says that in a low interest environment, many investors have been moving up the risk ladder to increase yield by extending maturities or moving down the credit quality ladder. But those strategies could backfire when rates begin turning upward.
A multi-asset portfolio can lower that risk by spreading bets among different asset classes with low correlations to each other. While he acknowledges that even a broad spectrum of income-producing assets could lose value in a rising rate environment, he believes that the diversification and hedging strategies make his portfolio less vulnerable to interest rate risk than a narrower band of fixed-income securities.
“The world has changed a lot since the old days when building portfolios around nine equity styles, then bolting on some bonds, was sufficient,” says Fredericks. “The fact that the fund has reached $11 billion shows that many investors agree on the need for a more diversified approach to income. And over the last few years, some of the best income opportunities have come from outside the bond market or in areas that are difficult for investors to gain access to through individual securities such as preferred stock.”
In his view, active management is also critical. “It is not enough to identify income-producing asset classes, construct a portfolio and take a step back. You need to tactically move a portfolio around to capture changing income opportunities.”
Fredericks says some advisors use the fund to replace some of their higher risk equity allocations and a similarly-sized portion of low-yielding fixed income. For example, advisors might sell 5% of their stock positions and 5% of their low-yielding bond positions and replace them with a 10% allocation to the multi-asset fund. Investors who have too high an allocation to cash or traditional bond strategies could simply replace some of those allocations with a flexible income strategy. Others might use the fund to fill in for securities that have done well over the last several years, such as high-yield bonds or real estate investment trusts, but are now vulnerable to a downturn. Or the fund could substitute for more volatile income producers such as master limited partnerships.
So far, the fund has delivered on its goal to produce a consistently high level of income with less volatility than a typical balanced portfolio of stocks and bonds. It has provided a yield of between 4.48% and 5.52% since inception and has been about 30% less volatile than a 60/40 stock-to-bond allocation. Recently, institutional class shares, which have a net expense ratio of 0.55%, were yielding about 5%.
Shorter Duration, More Covered Calls And Hedges
About one-third of the fund is invested in developed market stocks in the U.S. and Europe. While Fredericks takes a positive view of the U.S. economy, he believes a stronger dollar will continue to be a headwind for U.S. companies that do a lot of business overseas. “U.S. stocks aren’t cheap, and there is reason to be concerned about how much more the market here can rally,” he says. “And because of the stronger dollar’s negative impact on exporters, we prefer U.S. companies whose businesses are based on domestic demand.”
Many of the portfolio’s holdings are in more economically sensitive consumer and industrial sectors, which tend to do well when the economy is on an upswing. He says the improving labor market, rising consumer spending and increasing capital expenditures all bode well for such stocks, and that these cyclical names “will lead the market in a rising rate environment.” On the other hand, he believes high-quality, blue-chip dividend payers, which investors have been drawn to for years, could underperform as demand for their defensive characteristics decreases.
Lately, Fredericks has been adding to the fund’s European stock holdings, which represent a little less than one-third of the total stock allocation. He believes that with the weakening euro and low bond yields, “equities are the most attractive game in town in Europe.” (He’s been using hedging strategies to iron out the currency swings.)
Covered call writing has become an increasingly important part of the fund’s strategy over the last year. With market volatility on the rise, premiums on covered call writing have become more generous since last summer, particularly for the cyclical securities he favors for the strategy. “We usually write calls that are 5% to 10% out of the money to reduce the chance of having the stock called away,” he says. “And if a stock goes up 10%, that’s the most appreciation we get, we’re satisfied.” Fredericks adds that the yield generated from the covered calls allows the fund to “be more conservative than we otherwise would be on the fixed-income side. Because of the income generated by covered calls, we don’t have to go to the bowels of the credit ratings to get good yields.”
Only 1% of the fund is devoted to master limited partnerships, well below its high of 8%. Fredericks isn’t fond of their commodity price sensitivity and says their partnership structure and lack of transparency make them difficult to analyze.
The fixed-income side, which represents about two-thirds of the portfolio, invests in a mix of high-yield bonds, mortgage-backed securities, investment-grade debt, cash, floating-rate loans and emerging market debt. At 15% of assets, high-yield bonds represent the largest fixed-income class, but that level is well below the fund’s historical peak of 55% and close to its all-time low of 12%.
Fredericks says low oil prices have hit high-yield bonds particularly hard, since companies that issue them are often in the energy sector. “And when equity markets sell off, high-yield bonds follow,” he says. “The risk-reward equation is more attractive in the equity markets than in high yield.”
At 13% of assets, the allocation toward mortgage-backed securities is at a historic high for the fund. “This is one of the few segments of the bond market where we think price appreciation is likely. Home prices are going up, which means defaults should decrease. And with the improving economy, wage inflation is creeping in.” Most of the fund’s investments are in bonds backed by mortgages from the 2004-2009 era, which Fredericks began picking up at a steep discount after the financial crisis in 2008. Although the bonds have appreciated since then, he believes they still trade at a discount to fair value.
He uses a barbell approach for investment-grade debt, which accounts for 14% of assets. At one end are short-term investment-grade bonds, which he views as a “cash proxy.” At the other end are intermediate and long-duration “AA” and “AAA”-rated securities, which he believes would hold up well in a bond selloff if investors fled to safety.
He recently upped the fund’s allocation to floating-rate loans, which represent about 3% of assets. He bought many of them after a selloff in late 2014 brought prices down, and he believes they could move back into favor once the Fed decides to push interest rates higher.
While he believes it is likely that the Federal Reserve will likely raise rates in June, rate increases will be gradual and concentrated at the shorter end of the yield curve. For that reason, he is hedging out interest rate risk for shorter-term bonds with U.S. Treasury futures and going long on bonds in the 10- to 30-year maturity range to pick up some extra yield. Using this mix of strategies, Fredericks has whittled down the fund’s fixed-income duration to a modest 2.1 years.