Beyond risk: Building better income models

Efficiency is a powerful motivator. So, it comes as no surprise that model portfolio usage continues to grow. But what is perhaps worth an eyebrow raise is how concentrated it remains. Cerulli’s 2022 US Asset Allocation Model Portfolio report confirms that, by far, the bulk of model-related assets and flows have been in target risk-based strategies i.e.: 60/40 models, etc.

Over time, this led to an oversaturation of offerings and, thus, limited opportunity for providers to differentiate their approaches – at a time when differentiated services and investor outcomes are both a priority and a necessity. But the tide is turning, and a broader array of solutions are beginning to be offered in meaningful numbers.

• Custom models have the potential to provide meaningful differentiation now that technical and operational hurdles previously hindering “customization at scale” have been cleared. Our COO, Sachin Shah, provided detail around this in a recent insights post.
• Completion models fill an important gap for many advisor and client situations. For example, given rate fluctuations and an uncertain Fed, enhancing a high-quality core fixed income allocation with a diversified and opportunistic complement could be beneficial. Similarly, alternatives remain an area of focus. Their potential as a diversifier and an independent source of appreciation can be additive for some clients but approaches and vehicles will of course differ.
• Outcome-oriented strategies are gaining traction, from risk mitigation and tax optimization to income generation and beyond. Per Cerulli they are most frequently requested by advisors.

Frequency of Requests by Financial Advisors

Enhancing income models: Balancing flexibility and results

Multi-asset portfolios are especially well suited to income investing. By design they balance and integrate diversified sources of income with broad opportunities for gain.  But for taxable investors – a common use case – the portfolio adjustments needed to align portfolios with changing opportunities can create tax liabilities that hinder results, hinder opportunity, or hinder both. Additionally, the nature of generating yield within the portfolio also creates taxable income which are passed through to the client.

The role of stocks in income-oriented portfolios is important at certain times and nuanced all the time. The potential to diversify fixed income and generate price appreciation is balanced with (usually) lower income than that from bonds. And this calculus can change, sometimes rapidly. A rise in equity prices typically lowers yields in percentage terms. At this juncture rebalancing and realizing gains or not rebalancing and compromising portfolio construction are two less than ideal choices.

Looking at the fixed income side of the ledger, there’s a similar need for opportunistic flexibility – to find yield wherever it may be, whether we’re just looking beyond the Agg, across the yield curve or across the world. The Agg’s roughly 16% drop we saw last year was unprecedented. And while the market had recovered a little by year end, intra-year volatility took bond investors for quite a ride.

Hopefully we won’t see that kind of year again for some time. But whether the Fed is continuing to tighten, on pause or starting to think about reversing course, as with equities volatility changes where opportunity lies.

Decumulation is especially germane to the income model discussion. At some juncture, most investors will augment dividends and coupons by drawing down on principal, whether as a one-off event or as part of a longer-term income substitution plan. The tax consequences again become a headwind to portfolio performance.

Tax optimization changes the income calculus

Making models more tax-efficient for taxable accounts is now the most important product development initiative for model providers. Approaches taken can be as simple as the tried-and-true method of including municipal bonds. But integrating systematic tax-loss harvesting into income-oriented strategies can add an additional layer of value, differentiation, and results. Whether at the security or asset class levels, 55ip’s tax-smart platform delivers on this promise.

By definition, multi-asset approaches require evaluating risk and reward across investment asset classes. But now losses in one area can be systematically harvested to offset gains in another – providing direct tax benefits and, as a result, enhancing the flexibility of portfolio management by reducing the cost of entry and exit.  For example, rebalancing out of an equity allocation after market gains may be prudent but could create a tax drag. Reducing that drag enhances the manager’s flexibility.

55ip’s platform was designed from the ground up to be vehicle agnostic. Because the optimal vehicle for managing the U.S. equity component of an income portfolio (say a tax-managed SMA structure) may well differ from that of a completion position fulfilled by a certain ETF model, manager decisions can be made independently and without operational constraint.  

To help advisors fully realize their vision we’re also provider agnostic. The best provider of risk-based models may not be the best provider of specific outcome-oriented approaches. With 55ip, advisors can work with specific model providers for models available in the marketplace, choose to build their own investment strategies act as Portfolio Managers, or customize a strategy along with a model provider to develop their own constraints. Compromise is unnecessary.

Flexibility can be especially beneficial during decumulation. In our example, clients in need of income may have to sacrifice realizing gains in order to take funds from their investments.  However, 55ip’s Tax Smart withdrawal technology very well understands how to equally balance tax bills and tracking error to suggest to client the optimal positions which would need to be sold to raise cash for the client in a fiscally responsible manner.  Thus, sell decisions can pair security level losses with gains at either the security level within the US equity SMA or at the strategy level from outside. In both cases though, advisors have an additional layer of flexibility to cut the decumulation tax bill.

55ip: Partnering to deliver differentiated outcomes

Systematic tax optimization can yield significant benefits. For income-oriented models, 55ip’s sophistication and ease of use has the potential to add direct tax alpha and, as a result, expand a manager’s toolkit by reducing the tax-related barriers to portfolio optimization. Meaningful product differentiation and enhanced investor outcomes can be delivered.

If you’d like to learn more about 55ip’s ability to deliver your vision through our custom model solutions, click here to schedule a meeting.

The impact of a tax-loss harvesting strategy depends upon a variety of conditions, including the actual gains and losses incurred on holdings and future tax rates. The results shown in these materials are for illustrative purposes only and do not represent actual investment decisions. 

The tax-loss harvesting service is available for an additional advisory fee and the results shown represent the net effect of the advisory fees but may not consider the impact of fees charged by others, including transaction costs or other brokerage fees. The information contained herein is subject to change without notice, is not complete and does not contain certain material information about the investment strategy, including additional important disclosures and risk factors associated with such investment and information about fees, trading costs and taxes. Neither the U.S. Securities and Exchange Commission nor any state securities administrator has approved or disapproved, passed on, or endorsed, the merits of this document. More information at www.55-ip.com.

Past performance does not guarantee or indicate future results and there can be no assurance that any investor will achieve comparable results or that any return objectives will be met. No representation is made that any investor will, or is likely to, achieve results comparable to those shown. All investments involve risk, including loss of principal.