Solving The Income Riddle

Solving The Income Riddle 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 ultrashort-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 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.