Wealth managers are looking beyond fixed income products into private markets and exchange-traded funds.
Income is incoming.
Income investing is exploding in popularity, thanks in large part to climbing interest rates. Bond funds are on track for their best year on record, with $352 billion in inflows through July, according to a State Street report. Meanwhile, dividend funds brought in nearly $20 billion in assets in the first half of the year (on pace for the highest since 2022), while derivative income funds attracted more than $32 billion over the same period. That has put the category on track for its best year on record, according to Morningstar data. Advisors can help clients build out a diversified income strategy that takes advantage of several new income-generating products, but they should also make sure to remind clients that yield isn’t everything.
Obviously, investors nearing retirement are keen on income to fund daily living expenses. It’s particularly relevant for those who don’t have sufficient savings to meet their income needs and are facing a retirement that could potentially stretch decades, said Ethan Powell, CIO at Brookmont Capital Management. He called the cohort “the pig in the python working its way through the system.”
Then there are the investors who simply have a hard time tolerating risk and think we may be at or near the top of the market. “We’ve been continuing to climb this wall of worry with US equities,” said Brian Spinelli, Co-CIO at Halbert Hargrove. “Markets do correct, but I think people are looking for alternative ways to earn money on their portfolios other than just ride the capital appreciation of stocks.”
All About That Bank
Historically, investors looking to generate income were largely limited to bonds, especially prior to the financial crisis when interest rates were higher. Now, advisors can put their clients’ eggs in far more baskets by accessing private credit or using products like covered call or dividend exchange-traded funds to juice a little extra yield.
While private credit used to be the remit of institutional investors, asset managers have begun offering more retail-friendly ways to enter the space. “Asset managers realized pension funds and institutional clients weren’t going to be adding as much growth to them long term, and the retail wealth management space was,” said Spinelli. “Products started to come to market that focused on high levels of income, and that started to get retail investors interested.”
Private credit can offer higher yields relative to the public bond market, but such assets come with liquidity risk. “Since they are private transactions, they’re not as liquid as a treasury bond or a bond issued by a large corporation,” said Scott Lavelle, CIO of Diversified. “You have to be willing to have your money parked in a place for a longer period of time.”
Advisors should do their due diligence on the company before investing and shouldn’t always chase the higher yield. It’s worthwhile to take a more conservative approach in private credit, said Kutner. “You might be giving up a little bit of yield, but you’re putting yourself in a safer situation.”
Dividends With Downside
Still, investors need to monitor how the underlying stock is performing, “because if it’s paying a nice dividend but it’s not really growing, then it’s not really worth much,” said Kutner. “I’d rather have a stock that went up 100% in five years that pays zero dividends than a stock that pays 5% dividends, but it’s only gone up 10%.”
In a similar vein, investors can use option overlay or covered call ETFs, trading upside for current income but also with a bit of downside protection. Losing out on that growth “doesn’t mean it’s a bad strategy,” said Spinelli. “But you might be sitting there going: ‘Why am I not keeping up from a total return standpoint?’” They also aren’t particularly tax efficient, so investors with covered call strategies inside non-qualified accounts need to be aware of the tax implications.
Back to Basics. Sometimes the best approach to income isn’t chasing yield at all. Portfolios still need growth to combat inflation, and for clients with a higher income need, it may be useful to aim for a higher overall return and then trim off what a client needs to live on, said Bryan Byrer, founder of Millennial Financial Planning. After all, as with all equity strategies, covered call or dividend ETFs look good when markets are up, but can implode with a market reset. “How much of an appetite do investors actually have for when that happens?” he said. “Especially with what could seemingly be close to the top of the market, does it really make sense to put clients into more complex vehicles that are based on things that could blow up a little bit — or a lotta bit — in a market downturn?”
And that’s not to forget the bedrock of fixed income and the public bond market. “The meat and potatoes is usually where the best results happen,” said Byrer. “It’s not as fancy and it’s not as shiny, but there’s a reason why it usually works out the best.”
