Investors seeking income should diversify beyond the traditional 60/40 , according to Morgan Stanley. The firm has an income model portfolio that includes not only U.S. stocks and bonds, but also international assets, master limited partnerships, real estate investment trusts and commodities. “There’s a high correlation between fixed income returns and equity returns,” explained Jim Caron, chief investment officer of the portfolio solutions group at Morgan Stanley Investment Management. Different sources of income can manage duration risk on the fixed income side and balance out the income generating assets, he added. “That can start to bring down some of your correlation risk,” he said. “Having that diversification gives you stability in the portfolio, so you can hold on to it, so you’re getting that income.” Top-down approach The firm takes a top-down macro approach when deciding the portfolio’s allocations. For instance, if the team thinks the consumer is going to do well, they would overweight the consumer sector and potentially overweight equities. If they thought rates were going to come down, they would have more of an overweight in interest-rate sensitive fixed income. “Today we think the Fed’s not going to do anything, and the rates are just going to kind of move sideways, but economic conditions are good, so we’re willing to take a little bit more credit risk,” Caron said. The Federal Reserve opted to hold rates steady at its last meeting in June. Filling the buckets Within the fixed income bucket there is a mix of high-quality credit such as corporate bonds, asset-backed securities and mortgage-backed securities. Corporate bond funds, for instance, can bring in yields over 5%. For example, the iShares Broad USD Investment Grade Corporate Bond ETF (USIG) has a 5.3% 30-day SEC yield and 0.04% expense ratio. USIG YTD mountain iShares Broad USD Investment Grade Corporate Bond ETF year to date There may also be some high-yield bonds and floating-rate assets. Caron also likes emerging market bonds right now, particularly those from Brazil. “Interest rates are high, we think that inflation is coming down. We think policy rates have been set right,” he said. Indonesia is another area he prefers and overall sticks mostly with broad dollar-based emerging markets. In general, investors can get a pick up in yield in emerging market bond funds. For example, the Vanguard Emerging Markets Government Bond ETF (VWOB) . It has a 30-day SEC yield of 5.97% and an expense ratio of 0.15%. VWOB YTD mountain Vanguard Emerging Markets Government Bond ETF year to date The overall duration of the fixed-income bucket is close to five years. The equities allocation goes beyond the S & P 500 , which is heavily weighted towards mega-cap tech stocks. “It is going to have much more of a focus on quality dividend earners,” Caron said. The firm also likes artificial intelligence beneficiaries for equity allocations across its portfolios. That could mean areas like the managed care segment in healthcare or some construction companies that will gain efficiencies thanks to AI. “We’re trying to find the companies that are adapting and adopting new technologies that can benefit from AI,” Caron said. “They’ll be the winners, and then there’ll be the losers, and the companies that adopt this new technology well will be the winners, and that’s what we’re trying to invest in.” Another theme he likes is fiscal policy beneficiaries — those who will benefit from regulations out of Washington like deregulation or other fiscal policy. That includes financials and some energy and manufacturing, he said. Rebalancing with tax awareness The model portfolio gets rebalanced six to eight times a year, Caron noted. “A client in an income fund doesn’t want to see, like every other week, that their portfolio is being churned,” he said. “Plus, that also could create a tax event if you’re doing that, so, you’re really trying to be very tax aware … and hopefully you can sleep at night.”
