Investors 'need more than just income' in heightened inflation environment

Over the last three years, the world has experienced a global pandemic, spiralling inflation and one of the fastest rate-hiking cycles ever recorded. On one hand, investors have more choices when it comes to income-generating assets compared with three years ago.

That said, we believe income investors need more than just income in an environment of heightened inflation when real returns (adjusting for inflation) matter more than ever, says Eddie Cheng, head of International Multi-Asset Portfolio Management at Allspring Global Investments.

We believe global equities with higher dividends provide a compelling profile in helping our investors achieve their desired investment outcome, with the main reason being that higher-dividend-paying equities not only offer income, but, more importantly, they provide a robust source of return to protect investors' real purchasing power over the inflationary environment.

Certain equity income strategies may offer a solution to providing desired levels of income and protecting real purchasing power over the long term. However, balancing income and total return can be somewhat of a trade-off. 

We like to think of it as the equity income tug-of-war. Our approach seeks to overcome this challenge by combining two different sources of income to deliver a more consistent income stream in addition to long-term capital growth.

First, we start with a well-diversified, dividend-focused equity portfolio. Here, we leverage our investment process to combine the best of quantitative modelling, as well as a fundamental review to identify a high-quality company that delivers dividends directly linked to their business model. We then create a well-diversified portfolio in order to capture the different market drivers to retain the high potential for capital growth. We then enhance this income through collecting option premiums through an actively managed option strategy. We sell call options which allows us to sacrifice a very small portion of that potential upside in our equity portfolio in exchange for a much more stable and consistent option premium. 

We believe there are three core differentiators that make GEEI unique. First, we're able to preserve stock-specific alpha within our equity portfolio by selling options on indices instead of stocks within the portfolio, using a dynamic approach to allow the maximum possible equity market upside. 

Second, we're able to capture broad equity market exposure because we're able to invest up to 10% of our portfolio in low- or non-dividend-paying stocks, allowing for more growth exposure. 

Third, we explicitly avoid the style and structural biases that you often see in equity income strategies. We target balanced factor, industry and region exposures to deliver a well-diversified portfolio. 
This diversified and balanced approach helps overcome some common pitfalls of equity income investing. 

Across the market cycle, we manage portfolios with the goal of avoiding extreme style exposures and focusing on bottom-up stock selection by leveraging our proprietary investment process that has been developed, implemented and enhanced for over a decade. 

Whilst many investors rely on market timing, we concentrate on discovering mispriced stocks according to their future cash flows to generate excess returns and on building a more balanced factor exposure. 

For example, in 2022, many investors were selling technology stocks, expecting an impending recession—which markets are still awaiting—only to become buyers of tech stocks months later in the name of artificial intelligence (AI) and generative AI. We seek to understand the context of why asset prices are selling at a specific level and analyse company fundamentals daily using proprietary technology. 

The two sources of income are complementary to each other throughout different parts of the business cycles. For example, in down, flat and moderately rising equity environments, the option premium is expected to add to the distributable income. 

In sharply rising markets, when options are expected to detract value, strong equity gains help support the distribution. This natural offset between the equity and option strategies leads to a more stable distribution source and less volatile strategy overall. As a result, the consistency and volatility reduction from the option component has allowed the strategy return to compound at a higher rate over time. 

Opportunities & market outlook

Today's current market environment is characterised by a significant amount of uncertainty. Yes, inflation is moderating; however, pockets of stubbornness remain, and the expectation is for inflation to generally remain above the common 2% central bank targets. 

For income investors feeling whipsawed from rapid shifts across the income spectrum, our global equity enhanced income approach may offer a better solution because it not only targets a desired level of income, it also maintains the strong potential for long-term real return, which is a key feature investors are looking for to protect their purchasing power in a higher-for-longer inflation environment. 

By Eddie Cheng, head of International Multi-Asset Portfolio Management at Allspring Global Investments 

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