Building Efficient Income Portfolios

Total return is an incomplete perspective on risk for an investor who is focused on income and not liquidating principal, such as a retiree. In this article, the autors introduce a new utility function to determine the optimal portfolio allocation for an incomefocused investor which incorporates downside risk. We discuss the implications of taxes, since investments have varying tax rates, which can change the relative attractiveness of different asset classes. We find that incomefocused portfolios are generally less diversified than portfolios focused on total return. Efficient income portfolios have lower allocations to equities and asset classes such as REITs and government bonds, but tend to have higher allocations to asset classes such as emergingmarket debt and corporate bonds. Overall, these findings suggest that incomeoptimized portfolios may be an attractive alternative to totalreturn strategies for investors focused on current consumption. © 2015 Institutional Investor LLC.