In an increasingly volatile investing environment where the economy appears to have entered what the economist call a “late-cycle phase” the analysts at BMO Global Asset Management believe the best strategy to reduced portfolio volatility is to aim for achieving high income in both bonds and equities.
The risk of the US articular entering a recession in the next year or more looks to be increasing, according to the economic data. The ETF investment team at BMO suggest that the evidence from the last two economic cycles suggests that recessions follow on between 12 and 24 months after the yield curve has inverted – which is a leading indicator of a lack of faith in the immediate future.
When weighed up against the long list of geopolitical and economic risks facing the global economy, from the US to Europe, from China to the emerging markets, the BMO team look to approaches to take.
One line of attack is to try and avoid interest rate risk in fixed income via employing a barbell strategy.
BMO suggest investors can implement this strategy with only two ETFs, a short-dated bond ETF for capital preservation and a longer-dated equivalent for higher yield. “This strategy performs particularly well when yield curves are flattening (i.e. the shorter rates are increasing faster than longer-term rates),” they add.
Alternatively, they say, investors could look for yield without taking extra credit or duration risks via one-to-three year global investment grade corporate bond exposure. There is, of course, an ETF for that – BMO recommends just such an in-house example though others are available.
“This maturity bucket offers good diversification benefits given its limited drawdowns, attractive yield, low duration and credit risks, and low correlation to equities,” they suggest.
Of course, an easier way – or perhaps we should say the more explicable to the investor on the street – is via investing in high dividend companies. However, as BMO points out, this runs the risk of falling into the “yield trap”.
“US corporate profit growth is likely to continue to decelerate in 2019, with declining growth prospects, labour cost increases and tighter profit margins,” the team suggest. “Therefore, we believe it is advisable to screen for quality before screening for dividend yield.”
Such is the approach of the BMO Income Leaders ETF – again, others are available – which tracks the MSCI Select Quality Yield Index.
Other route are also available. Investors can opt to diversify away from traditional sources of income by using derivatives. The BMP team suggest that covered call overlays, whereby index call options are sold against an equity index in exchange for an immediate additional cash flows (the option premiums) on top of the underlying stock dividend, can increase the overall yield of the portfolio.
“In this way, investors can combine superior income and investment growth from market returns,” they add. “This strategy has been comprehensively implemented in the BMO Enhanced Income ETF range, which takes away the operational complexities for investors.”
BMO conclude with some words of warning. “Overall, we feel it is timely to gradually de-risk portfolios,” they say. “We believe defensive equity strategies (defensive sectors focused ETFs, and quality and yield strategies), alongside high-quality credit ETFs that offer additional income and diversification, can help investors protect against the risk of an equity bear market as well as reduce the volatility of portfolios.”