Solving The Income Riddle

May 06, 2015

[This article originally appeared in our May issue of the ETF Report.]

 

We asked a number of advisors how best to obtain yield in the current low-rate environment, which is characterized by very low rates and low inflation, even as the Federal Reserve prepares financial markets for the possibility of its first rate increase in short-term borrowing rates in nine years. Specifically, we asked how they would go about advising a client who needs a portfolio that generates 5% income annually, and what product(s) would they use to achieve that goal.

One of the techniques Toroso uses to address the desire for yield in today’s very difficult environment is to build an “income barbell portfolio.” One example of this approach combines specific weightings of cashlike ETFs such as the Guggenheim Enhanced Short Duration Bond ETF (GSY | B) and income-oriented ETFs such as the PowerShares CEF Income Composite Portfolio (PCEF).

Using the two, we can synthetically construct a higher-yielding and less volatile portfolio than investors can find with traditional bond ETFs. A combination of 56% PCEF and 44% GSY provides a yield of about 5% while maintaining 44% of the portfolio in ultra-short-term lower-risk fixed income. By actively rebalancing back to the desired yield, when dislocations occur in the fixed-income market, investors should be able to maintain a 5% yield with relatively low volatility. To learn more about this, look at the article we wrote about this in a recent article on ETF.com titled “The ETF ‘Barbell’ Income Solution.”

Nowadays it seems a scary proposition to depend solely on fixed income to generate a 5% yielding portfolio.

Even stepping out into long-dated investment-grade credit will only generate about 3.5%. Inevitably, the next move would be to lower the quality of the portfolio and move into high yield. Along this same risk-adding theme would be to mix in more equitylike income producers such as MLPs, REITs and dividend-paying equities. However, using solely fixed income seems scary, as does using solely yield-producing equities, as we’re in the midst of a prolonged bull market.

With the Fed essentially propping up equity and fixed-income markets, any move by it could prove unsettling. It would be prudent to use a diversified portfolio consisting of fixed income and equities. But because of the ever-evolving market we seem to be in, allocating at least a portion of this portfolio to a tactical strategy that can move between said asset classes can provide a degree of safety and flexibility.

Additionally, I think using various option strategies can supplement yield and allow for further diversification. Selling volatility can generate yield, especially if we enter a higher-volatility regime. Moreover, using option strategies can dampen some of the added equity risk taken on.

5% yield? Whenever you’re trying to generate more income than the broad market offers, part of your brain should be wondering if you’re overextending yourself. Remember, the easiest way to double your yield is to lose 50% of your principal value. But nobody wants that.

A few asset classes currently offer yields north of 5%: High-yield corporate bonds, emerging market debt, preferred stocks and MLPs come to mind. The problem is, they should all experience negative returns at the same time if the market’s risk appetites change and there’s a flight to quality. So while it’s possible to build a portfolio that yields 5%, expect it to be lacking in diversification and remain vulnerable to drawdowns. No good fiduciary would recommend that type of allocation.

If 5% is absolutely necessary, you might start out by barbelling your risk, using a combination of higher-yielding asset classes and some cash reserves. Hopefully this approach could allow you to accrue several months of strong performance and rebalance excess returns into your cash position, which would become an ever-increasing portion of the portfolio over time.

The cash serves as a diversifier that will hold its value during a flight-to-quality episode, and can be put to work when the markets sell off and new opportunities arise. With each round of rebalancing, the goal should be to introduce more and more diversification. In other words, each time you’re dealt a winning hand, celebrate by taking some of your chips off the table. If you’re going to be aggressive, do so by aggressively defending yourself against future drawdowns.

 

 

There is a quote by the famous Yale law professor and legal commentator Alexander Bickel: “No answer is what the wrong question begets.”

So be wary if you get any answers with respect to specific securities to a question on how to get 5% yield in the current environment. The right question and answer—and one I would pose and try to answer for any advisor—should be, “What is the risk and return profile and horizon for this client?” And the follow-up question is: “Why does the client ‘need’ income, and how is that term defined in the current macro environment?”

If “need” is defined in the distributional sense, as in outlay requirements for foundations or to support a living standard (like a required minimum distribution of an IRA), then the answer is simple. Both of the clients in this case—foundation and retiree—would fall into conservative or capital-preservative strata in a risk profile.

Those clients should have been shifted long ago—at the beginning of the zero-bound-nominal negative real Fed funds policy shift—into liquid multi-asset income strategies where the returns are a combination of yield, dividends and capital gains. The definition of “income” means a lot more than “yield,” because just taking on high-yielding products to produce “yield” or “income” will subject this class of clients to far more risk and potential illiquidity than their profile suggests.

I find it fascinating six years into this rates environment that there are still many advisors and their clients defining “income” in preglobal balance-sheet recession terms.

We suggest investors divorce themselves from the idea that liabilities must be funded by income and income alone. Instead, it’s important to remember there are two ways to generate portfolio returns: either via income or capital gains. What’s more, it’s our view that the current environment has actually skewed return profiles toward the latter, at least in the near term.

Since 2009, quantitative easing has been the response of choice for deflation-fighting central bankers around the world. At its core, QE is specifically designed to suppress yields in an effort to push investors further out on the risk spectrum to reflate asset prices. By their very design, these programs tilt the scale away from income and toward capital gains. It’s suggested that investors shouldn’t “fight” central bankers, and pursuing yield alone in this environment feels a little bit like that.

With the Fed officially ending its QE program in 2014, the United States is now a tough environment for income-seekers and total return-seekers alike. Instead, we suggest investors look abroad. Consider the iShares MSCI EAFE Minimum Volatility ETF (EFAV | B-64), which yields just more than 3.0%. Roughly 40% of the fund is allocated to Japan and the eurozone.

Both are areas that have reasonable valuations, and central bankers are still aggressively pursuing QE, suggesting future gains will more than make up for the shortfall in any 5% yield bogey. As an added bonus, the product is even designed to have a lower-volatility profile—a favorable attribute for most income investors.

 

 

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