Kensington Brief: Managed Income – Diversifying the Core

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In February 2023 we laid out the case for Dynamic Growth as a core equity allocation predicated on how incorporating investments with low correlation to the market (and each other) may benefit portfolio performance and provide true portfolio diversification. In this Brief, we will provide similar analysis for the Kensington Managed Income Strategy and demonstrate how utilizing Managed Income as a core component of a diversified bond portfolio may be advantageous, particularly in a rapidly changing market landscape.

A Case for Core Fixed Income

Investors use Managed Income in various places within an overall fixed income allocation. One of the challenges in identifying its most appropriate place is that it doesn’t fit neatly into most investor’s predefined fixed income boxes. Rather, its tactical nature allows it to shift its characteristics to best suit the prevailing market.

Given the Strategy’s focus on higher yielding fixed income, some utilize it as a high yield fund. Others, given its unique Risk-On/Risk-Off methodology, choose to view it as an “alternative” or non-traditional bond allocation. While all portfolios are unique, and Managed Income may be utilized as a high yield or alternative allocation, we believe that a more appropriate allocation for the Strategy is as a core fixed income investment, complementing existing passive allocations at the centerpiece of the portfolio.

One of the primary reasons for this is that Managed Income, despite investing in securities that would typically not be considered “core” fixed income assets, has demonstrated over time a risk profile in line (or better) with bond offerings often used for the core piece of bond portfolios. Let’s evaluate a series of risk statistics for Managed Income versus the iShares Core US Aggregate Bond ETF (ticker: AGG), which we’ll use as a proxy for a traditional core allocation:

Managed Income outperforms in virtually every risk category despite its typical allocation to higher yielding fixed income. One of the ways the Strategy has been able to accomplish this is by operating on a Risk-On and Risk-Off basis, shifting its portfolio offensively and defensively based on Kensington’s quantitative assessment of the market opportunity, positive or negative. The objective of this methodology is to identify and participate in rising markets and shift defensively when our quantitative system determines there is weakness in the market, with the goal of sidestepping volatility and avoiding drawdowns. This is perhaps best illustrated by evaluating the Strategy’s upside and downside capture ratios, which determines how much the Strategy participates in the upward and downward movement of its stated benchmark. For Managed Income, that benchmark is the Bloomberg U.S. Aggregate Bond Index, a proxy often utilized for core fixed income, as we did above.

Historically, Managed Income has participated in over 100% of the Aggregate Bond Index upward movement, while primarily avoiding the benchmark’s downside movement. In short, the Strategy acts more like a core fixed income strategy when you want it to (upside) and less so when you don’t want it to (downside).

Asset Correlation

The cornerstone of portfolio diversification is the ability to identify and utilize assets with low correlation to each other. As you would expect from the data above, Managed Income maintains a low correlation to the Aggregate Bond Index at 0.26 since inception, which is a key consideration for pairing it with more traditional core holdings. One aspect of correlation that is often overlooked, however, is that correlations are not static. Often during periods of market stress, traditional investments that would typically show low/lower correlation to each other see an increase in correlation, reducing portfolio diversification when it is most needed.

This again is where Managed Income’s Risk-On/Risk-Off system can be additive for portfolio construction. As seen in the chart below, the correlation between Managed Income and the Aggregate Bond Index is adaptive based on portfolio positioning and can seek to demonstrate high correlation to the Index when the market is deemed to be strong and low correlation when the market is deemed to be vulnerable.

Differing Rate Environments

Another key aspect to evaluate when determining what will make up the core of your fixed income portfolio, particularly in today’s ever changing rate environment, is how the investment performs during differing rate regimes, both rising and falling. If we evaluate the last 8 time periods in which the Federal Reserve meaningfully increased or decreased the Federal Funds rate (below), we see that Managed Income has performed admirably in both rising and falling rate environments.

Portfolio Impact – Diversifying the Core

Ultimately, we believe the most important factor when evaluating a new investment for portfolios, and where they fit in a portfolio, is what impact it has on the overall asset allocation in terms of portfolio risk and return. So, let’s evaluate how Managed Income impacts a portfolio when utilized as a complement to an otherwise diversified fixed income portfolio. For this analysis we will use the Vanguard Total Bond Market ETF (Ticker: BND) as a proxy for an overall US fixed income allocation, as the ETF spans across the fixed income spectrum. Comparing a portfolio made up solely of BND versus a portfolio split evenly between BND and Managed Income for the period January 2008 to March 2023 yields the following results across numerous portfolio statistics:

The Blended Portfolio, which incorporates both a passive (BND) and active (Managed Income) strategy has historically outperformed the 100% passive portfolio (BND) in virtually every statistical category including annualized return, standard deviation, max drawdown and each of the risk adjusted return metrics (Sharpe, Sortino). It is for this reason we believe utilizing Managed Income as a complement to existing core bond allocations makes sense for most investors. Managed Income’s tactical approach offers a unique and compelling solution to pair with traditional passive fixed income securities to better diversify fixed income portfolios across an ever-changing fixed income environment.

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