Engineering equity return stream: Top-down, bottom-up

The world of zero interest rates presents a number of investment challenges and in our view calls for new ways of thinking in order to create new betas, new alphas, and new ways of constructing portfolios. Although there are no new asset classes, there is the potential to create new beta and alpha return streams from what exists. This is possible because macro conditions are manifest in the spending and incomes of businesses, creating the potential to engineer new cash flow streams from collections of companies whose cash flows and pricing are fundamentally driven by specified macro conditions. The returns of these engineered equity portfolios can be further refined by combining them with hedges or diversifying exposures in other liquid markets, and this can be done either passively or actively. The net result can be newly engineered return streams to create portfolios which have less risk at the same or higher returns as traditional equity or multi-asset portfolios, without holding nominal bonds.

One way that we have applied this way of thinking is through what we refer to as stable cash flow equities. The goal is to engineer a stable cash flow stream from equities in order to replicate some of the properties of a bond. The process starts with identifying stable and reliable types of spending in the economy, connecting that spending to the revenues received by the companies that offer those goods and services, and then screening for a relatively unobstructed passage of that revenue to earnings. The selected companies are effectively used as pass-through vehicles to earn a sliver of the cash flow stream generated by stable forms of spending in the economy. The constituents of the portfolio rotate over time to continuously source their income stream from the associated type of spending, creating a new cash flow stream that you can hold passively or manage tactically. Below is what that cash flow stream looks like compared to the cash flow stream of the overall equity market in the US since 1963 and in other developed countries since 1990.

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