This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Scott Kubie, chief strategist of Omaha, Nebraska-based CLS Investments.
Yield chasers may not be as crazy as we think. From the standpoint of modern portfolio theory, investing in asset classes with elevated yields is suboptimal (meaning, crazy). Portfolios focused on yield don’t diversify the allocation as well as more diversified portfolios. This leaves the client exposed to a series of avoidable risks:
- Interest rate risk: Securities with high yields are more sensitive to changes in interest rates.
- Sector risk: Higher yields are found more often in utilities and REITs, while less frequently in technology.
- Liquidity risk: Income portfolios shy away from liquid Treasury bonds and favor less liquid corporate bonds.
The net effect is a portfolio with extra risk for an investor whose objective is steady income. It seems like a dangerous match for the many retirees who use this strategy.
How Do You Define Risk?
Before heaping on more criticism and shame, it is only fair to examine the argument above for weaknesses. Much of it hinges on the definition of risk. My experience is that most portfolio analysis relies on monthly standard deviation (or other performance measures) as its measure of risk.
But income strategies assume extended holding periods, where income is spent and the securities are rarely sold. Thus, the income investor argues the three risks above lack relevance:
- The income investor isn’t as concerned about higher rates pushing stocks down as she is about the income received being sufficient to meet her needs.
- Nondividend-paying stocks may go up or down, but they don’t help match her income goals.
- If she doesn’t sell securities to meet expenses, liquidity isn’t an issue.
To evaluate these ideas, a revised definition of risk, focusing on income, is needed. Nobel Prize winner Robert Merton has filled this gap. He proposed, in the Harvard Business Review, that investors should evaluate investments based on income volatility rather than price volatility. Merton argues, “But if the goal is income for life after age 65, the relevant risk is retirement income uncertainty, not portfolio value.”
Measuring Income Volatility
The below graph measures the monthly performance volatility and annual income volatility of a select group of income-producing asset classes, broad market indexes and low-risk assets. (See note at end regarding the choice of risk measure.)