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The Strategic Approach to Income Investing


 As an investor in today’s world fraught with risks, how does one stay focused on their own personal goals and objectives without succumbing to the whimsical fear and greed cycle that Wall Street would gladly see you participate in? 

With so many forces at work to coax you into “trying something new” or taking risks that you might not understand with your hard earned dollars, staying tried and true to a single investment philosophy over a lifetime can seem both unimaginative and unambitious.  I believe the single most abusive part of the relationship investors have with their money is a pure lack of strategy and adaptation.

Having a strategy isn’t as simple as naming the particular investment discipline that fits your needs, such as income. A strategy is a way of thinking, analyzing, and reacting to changes in an environment so that a desirable outcome is achieved.  A strategy has rules, and boundaries that work to protect you from influences that might lead you towards an undesirable destination.  And the single largest benefit and most important feature to a strategy is that it clearly defines the atmosphere that you operate within.  At Fabian Capital Management, we implement and then consistently adhere to a clear and definable strategy for our clients.  

The Sleeves…

Our strategic approach to income investing begins by dividing the portfolio up into four asset classes, which we refer to as “sleeves”.  The four sleeves consist of fixed-income, equities, alternatives, and cash. Subdividing a portfolio allows us to focus on characteristics that don’t always apply to every asset class; such as duration as it relates to fixed income securities, or volatility as it relates to equities. It gives us the ability to drill down and hand pick investments that are going to intermingle well with one another relative to the current market environment. 

Within that framework, we step back and analyze the individual sleeves to ensure they merge together in a way that creates a workable and cohesive portfolio.  The final result is a selection of funds that strategically aligns itself with our primary objective of income and secondary objective of capital appreciation.  In addition, it must always adhere to our strict risk management permissions.

The Fixed Income Sleeve…

A strong income strategy is grounded in the use of fixed-income securities that have been selected to adapt to interest rate changes.  Our fixed-income sleeve analysis starts with a detailed look at both duration and credit exposure.  Both factors are vital considerations that determine how the sleeve will react to a swift selloff in the equity markets, or a steadily rising interest rate environment attributable to robust economic expansion. 

Duration is a key factor in determining the volatility of the sleeve because it is the primary measure in which a bond fund will react to changes in interest rates.  For example, if we find ourselves in a steady downtrend in interest rates, we would want to maintain a higher duration to capitalize on the potential for price appreciation.  Conversely, if we feel rates have reached an intermediate-term low and begin to trend higher, we would reallocate the portfolio amongst positions that are very short in duration.  A short duration bond fund has the ability to still pay a modest yield, but also preserve capital.   Actively managing duration allowsus to both control risk andstrategically distribute the portfolio anywhere on the yield curve to capitalize on the current trend in interest rates.

Identifying and understanding the underlying risks associated with any investment we own for our clients makes up the core of our income strategy.  The risk of credit exposure can most easily be explained as the ability of a borrower to repay both principle and interest on time.  Economic strength acts as the primary barometer that inspires the level of credit exposure we will subject our client’s capital to.

Typically, bonds carrying lower credit ratings are more apt to rise in sympathy of a strong economy due to the confidence in the borrower’s ability to repay its debts. However, a weak economic environment may place stress on an already high risk borrower, causing the confidence in their ability to repay and the price of the bond fund, to plummet.  We assuage this type of risk with a detailed fundamental analysis of the credit exposure within each fund allocation we make with our client’s capital.   That way, risks are controlled and the appropriate size within the sleeve is established. 

Fabian Capital Management uses a security selection process that focuses on the opposing forces of duration and credit exposure, so that the intermingling of the individual positions results in a portfolio that is low in volatility and high in current income.  Maintaining minimum and maximum exposure limits keeps the portfolio in balance and bridges any pitfalls that might arise from an oversized position to either type of exposure. 

Fabian Capital Management can access any area of the global bond market including: corporates, municipals, mortgages, or treasuries from foreign or domestic issuers.  After honing in on the perfect allocation matrix, we screen every applicable mutual fund or ETF to analyze fund expenses, underlying portfolio construction, active vs. passive management, and past performance.  Our bottom up analysis of a bond fund’s composition enables us to target any area we might find to be undervalued. 

The overriding objective of the fixed-income sleeve is to select securities that adapt to any interest rate climate to keep volatility low and ensure the best possible investment outcome is achieved.

The Dividend Equity Sleeve…

One of the single largest conundrums to income investing is maintaining the appropriate amount of dividend equity exposure in a given market environment.  You may ask yourself: How does one invest in a stock market that changes so quickly, and can remain irrational longer than a conservative investor can remain solvent?

Unfortunately, there is no simple answer because the future is unknown.  However, one thing we know for sure is there will be opportunity and luckily it’s presented to investors quite often.  The key to maximizing this opportunity is having a game plan to capitalize on trends that frequently emerge around the globe. 

Equity volatility can test an income investor’s resolve as they wait for the dividends to roll into their account on a quarterly basis.  Fabian Capital Management has a unique way of expanding and collapsing the equity sleeve of our portfolio so that dividend income is maximized, and volatility minimized.  Determining how much of our portfolio should be devoted to dividend paying equities has to do with where the overall market is relative to its long-term moving average. If stocks currently trade above their long-term moving averages, conditions are bullish and therefore merit a higher dividend-equity allocation. Conversely, if stocks trade below their long-term moving average, then conditions are bearish and that merits a lower level of dividend-equity exposure.

The dividend equity sleeve is made up of both core and strategic positions, with core positions representing a more broadly diversified index or equity strategy that we plan to hold for market correlation and income.  Strategic positions usually represent sectors or special situations developed through our investment process.  Strategic positions can also represent a short term trade that can be used to our advantage during times of extreme optimism or despair in the market.

Acquisition or reduction of equity exposure can be made into those types of intense fear or greed cycles.  For example, during a correction when we have determined price levels have reached a low in relation to their long term trends, equities can be purchased opportunistically in small amounts.  As worries subside, small amounts of equities can be exited into market strength or after the market has extended to areas well in excess of normality. 

We hold a single iron clad philosophical belief in our dividend equity strategy: A sell discipline will be honored on every position we hold for our clients.  You have to know when to cut your losses and move to the safety of cash when stocks decline past a pre-set point.  Our promise to you is that core belief in risk management will never falter.  

Equity volatility can be viewed as either a positive or a negative and exchange-traded funds (ETF’s) make excellent vehicles to profit from it.  We have chosen to integrate ETF’s into our equity sleeve because of a few unique traits: with the first being the benefit of daily liquidity, so we can get in or out in a hurry if conditions warrant it.  The second being their transparency, so that we know exactly the individual stocks we own for our clients.  Lastly, ETFs are very cost effective with internal expenses typically less than half of their mutual fund counterparts. 

ETF innovation has led to the creation of funds devoted to almost every industry group and sector available.  This means that if we choose to invest in global utility stocks which are known for their high dividends, there are a myriad of choices at our disposal.  

Our approach is unique in its ability to be active and shield our investor’s capital from an unfavorable equity market.  In addition we can reallocate this capital to a more favorable sleeve during periods of time that dividend equity opportunity is low, resulting in better all-around portfolio stability.

The Alternative Sleeve…

An area that sees very little utilization from typical portfolio managers is alternative assets.  These funds can complement a traditional portfolio approach to both enhance yield and total return.  Our definition of alterative assets includes: preferred stocks, REITS, MLP’s, closed-end funds, or convertible and floating rate bonds.

Security selection in this sleeve is evaluated primarily on the type of correlation we would like to emulate due to the fact that many of these assets don’t track exactly with the stock or bond markets.  Our dynamic approach with alternative assets allows us to deploy our client’s capital to rising asset prices or high income generation, even if we don’t feel comfortable with the current risks in equities or interest rates.  

For example, in a falling interest rate environment preferred stocks can offer attractive yields well in excess of their common stock counterparts.  In addition, they are higher in the capital structure and even offer the opportunity for price appreciation if the company’s fundamentals improve.  There are specific instances that timely investments like this can greatly enhance portfolio yield while also growing principle value. 

The Cash Sleeve…

Fabian Capital Management has developed our Strategic Income Portfolio to seize opportunity in any area of the market that conforms to our primary investment mandate of income and capital preservation.   We designed it to both capitalize on volatility and get defensive in the face of macro-cycles while still maintaining focus on our client’s long term goals. 

Every so often we run across a period of time that investments among equities, bonds, or alternatives would subject our clients to excess risk.  During these times we utilize the fourth and final sleeve of our portfolio which is cash.  Cash is something investors commonly find themselves with either way too much of, or not enough of, given the current financial climate. 

We find ourselves truly comfortable with the vantage point that cash offers because of the unique break to look out over the entire investment landscape without a clouded or obstructed view.  Cash is a place that provides stability between points of maximum opportunity, or between security research and investment theme development.  Cash is a place of strength, whether we are moving into cash after taking gains off the table and evaluating our next move or to reduce risk when market volatility soars.  Either way it will always play a pivotal role in our portfolio strategy.

Conclusion…

By dividing our portfolio and segregating our strategies into sleeves, we believe we can better focus and hone our client’s portfolio allocations to profit from low risk, high reward opportunities.  Allocations look vastly different in any given market but can be quantified by three different phases.  In our Bull Market allocation we would strive for high exposure to both the dividend equity and alternative sleeves.  Naturally this would lead to low allocations to the fixed-income and cash sleeves.  Juxtaposed by our Bear Market allocation, we would have very high allocations towards the fixed-income and cash sleeves and very little or no dividend equity and alternative asset exposure.  

Finally, in the vacillating phases that occur in between up and downtrends in equities or interest rates, we seek a more balanced transitional allocation that seeks to keep capital protected but also vested to receive the benefits of income and total return. 

The right mix of income-generating assets and the expertise to navigate through challenging market conditions are two critical components of the Strategic Income Portfolio that Fabian Capital Management has designed from the ground up and implements every day for our clients.  Rules and boundaries are administered to keep clients from experiencing the feeling of lost opportunity or lost money.   Both can feel equally frustrating.

By far the biggest problem we see with new client income portfolios is they tend to be too concentrated in one asset class. Sometimes, a high concentration in one sector works well, but over time, it will doom your income holdings to a life of volatile or mediocre returns.  We believe that the best way you can achieve both capital appreciation and income generation is by strategically allocating your income portfolio among the four asset classes outlined in this report. But we can only help you if you get in touch with us first. 

Success requires planning, and planning for success is what we do at Fabian Capital Management. We are a fee-only wealth management firm that helps clients achieve their goals by providing a clear investment plan, and implementing it decisively. At Fabian Capital Management, we help you take the steps necessary to get your income portfolio on the right track.

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Comment   |  6 years, 7 months ago from Irvine, CA