How We Build Our Income Portfolios

Summary

• Welcome to another weekend blog post from Systematic Income where we describe our Income Portfolios.
• The three Portfolios target different yield ranges by combining income-producing sectors with appropriate investment vehicles to minimize portfolio risk for a given yield range.
• The key differentiation from other services, in our view, is the explicit focus on risk control through a wide array of mechanisms.
• Take advantage of our max-20% discount this weekend and take a 2-week free trial of Systematic Income.

Welcome to another weekend blog post from Systematic Income where we discuss our suite of Income Portfolios maintained on the service.

The service hosts three portfolios which targeting three different yield ranges

• Defensive Income: 4-5%
• Core Income: 5-7%
• High Income: 7-10%

The portfolios are constructed using two main levers of asset sectors (outer ring below) and investment vehicles (inner circle). Both are used to ensure the portfolios are taking minimal risk to achieve a given yield range.

Our Approach To Income Portfolios

We use the following principles in building our suite of income portfolios:

The portfolios utilize the full spectrum of risk / reward on offer across different types of income vehicles from open-end funds like ETFs and mutual funds, to senior securities like preferred stocks and baby bonds, to unleveraged, term and perpetual CEFs and to common equities. Different investment options are evaluated with an eye to their resilience as well as offered yield per unit of risk.

Our portfolios are focused on assets that generate actual income rather than assets that merely boast high distributions. This may seem like a small point but it's an essential element of these portfolios. The advantage of this aspect of portfolio design is two-fold. It provides a clearer picture of the sustainable income generating capacity of the portfolio. And it makes the portfolio more resilient since funds that overdistribute are more likely to cut their distributions and lead to permanent principal and income loss.

We follow an anti-cyclical approach to investing. This involves dialing back risk somewhat during a late-stage cycle environment - when valuations are rich and yields are low. Because markets tend to mean revert this tends to boost both total return and subsequent income levels because of the ability of portfolios to maintain value and enable a reallocation into higher-yielding assets during periods of drawdowns.

The portfolios are designed with an eye toward risk mitigation with allocations to open-end funds, term CEFs and low-leverage CEFs, securities with strong risk-adjusted yields, funds that utilize more robust leverage mechanisms, securities that have proven to respond to drawdowns in a more robust fashion and others. Dry powder allocations tend to avoid perpetual CEFs.

Our portfolios tilt to assets that are likely to maintain their income levels through the cycle. This is implemented by a significant weight to senior securities like preferred stocks and baby bonds that have fixed coupons. CEF allocations are made with a nod to funds with a strong forward distribution coverage profile.

CEF portfolio allocations take into account which sectors have historically outperformed open-end funds and which have not. Some CEF sectors, in particular equity-linked sectors, are consistent underperformers of sector ETF benchmarks despite boasting leverage. CEFs are also managed with a view to avoid value traps.

All of the portfolios, to a varying extent, follow a barbell approach with pockets of relatively defensive assets alongside high-yield assets. This allows for both diversification and rebalancing and acts as an additional source of return for the portfolios.

The portfolios are maintained with an awareness of hidden return drags across certain sectors such as loan refinancing, default rates, negative yield-to-call securities and others.

Portfolios aim for diversification across various risk factors such as cyclical vs. defensive, floating-rate vs. fixed-rate, and others.

Allocations to passive vs. active investment vehicles are carefully considered in light of historic alpha generation capacity of active positions in a given sector alongside typically higher active fees.

The portfolios tilt away from more fragile investment vehicles such as CLO equity CEFs, CEFs with strict leverage caps, highly-volatile sectors managed in CEFs as well as highly cyclical and vulnerable common stock of mortgage REITs, REITs and BDCs. Exposure in these sectors tends to be owned via preferred stocks.

The portfolios aim to reduce the potential for permanent capital loss and income loss by matching sectors with appropriate investment vehicles and generally avoiding combinations that have time-and-again proved to be inappropriate for long-term income generation such as MLP CEFs, CLO equity CEFs, mREIT common stocks etc. Where possible, more resilient securities are used such as preferred stocks in these sectors.

The portfolios tilt away from CEFs with more fragile leverage structures such as funds with hard leverage caps or funds that rely on less sticky mechanisms such as tender option bonds. Open-end funds that use leverage are also used, where possible, as a way to avoid CEFs trading at a premium as well as to improve the risk profile of the portfolios.

The portfolios take a forward rather than backward-looking perspective on income generating capacity of CEFs by anticipating changes in leverage costs and earnings levels.

Portfolio allocations are made with both a top-down sector approach as well as qualitative and quantitative bottom-up fund and security analysis.

In addition to income and rebalancing opportunities, the portfolios are managed with an eye to other rich sources of alpha, available particularly in the CEF market.

As a final point, it should go without saying that these model portfolios are provided on an impersonal basis with no consideration to anyone's individual circumstances and should not be regarded as investment advice. Please do your own due diligence and make sure any information you receive here is appropriate for your circumstances.

Portfolio Presentation

The income portfolios are housed in the Strategic Allocation Tool.

Apart from the actual portfolio of securities there are 7 other pieces of information.

1. The name of the portfolio you are currently looking at.

2. The yields of this portfolio.

There are two different yields calculated for each portfolio. First, is the current yield. This is the familiar metric that shows the annualized rate of the last distribution divided by the current security price and aggregated across the portfolio. As many investors familiar with preferred stocks and baby bonds know, current yield is not the right yield to look at given the optionality embedded in these instruments. Please refer to our Guide to Preferred Stocks for a more in-depth discussion of different yield metrics but suffice it to say that yield-to-worst (YTW) is the better metric for these instruments because it takes into account the possibility of a call by the issuer.

We can extend this analogy to closed-end funds where the current yield is not the best metric of the income actually generated on investor capital. This is why many investors get sidetracked by funds that boast double-digit yields which earn only a fraction of this, dilute the investor with repeated rights offerings and cause permanent capital loss when the time comes to cut the distribution.

This is why we also calculate a metric we call the expected yield. It is calculated as follows:

• Preferred stocks / Baby Bonds = yield-to-worst
• Open-end funds (ETFs, mutual funds) = current yield
• Perpetual CEFs = Current yield (aka earnings yield or current yield x distribution coverage)
• Term CEFs = Current Yield + Pull-to-NAV Yield (discount / years to termination)

This metric gives a better picture of the yield the investor is most likely to experience.

3. A short description of the investment goals of the portfolio and its approach.

4. A breakdown of portfolio statistics. This table shows the weight composition of the portfolio by sectors and by investment vehicle type. It also shows both the current yield and the expected yield across all the entries.

5. An illustration of the key sectors and investment vehicles that are expected to make up the portfolio.

6. A backtest performance of the current composition of the portfolio. This is not the actual performance of the portfolio since inception, since the composition will change from time to time. Instead it is how the current portfolio would have behaved over the recent past. The chart is intended to provide some intuition about how the current portfolio is expected to behave across the trading environments we have seen recently.

7. The actual composition of the portfolio split across different investment vehicles with their relevant metrics

Thanks for reading!

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