Many ETF investors find themselves in that unhappy place
between a rock and a hard place this year. Stalling global growth
has seriously crimped stock portfolio returns, while delays to
further interest rate hikes are likely to keep bond yields
tightly leashed well into 2016.
To the rescue come equity and alternative income sources, such
as master limited partnerships (MLPs), real estate investment
trusts (REITs) and high-
. Exchange traded funds investing in these asset classes offer
investors a shot at capital appreciation, while their attractive
yields pad out portfolio returns.
They're especially valuable investing tools for income-focused
investors who may be planning for retirement.
"When rates remain unusually low for an extended period of
time, investors must consider yield-bearing investments other
than bonds to bridge the gap between the prevailing rates and
their income requirements," says Jay Jacobs, director of research
for Global X Funds, a provider of several ETFs that fall in this
Jacobs recently participated in a Schwab ETF OneSource panel
on new approaches to income and dividend investing. His firm
accounts for several of the best-performing ETFs year to
Global X SuperDividend US (
) is up 2% through March 10 vs. a 2% fall for SPDR S&P 500 (
So what are all the ETF strategies that investors can use to
find income beyond bonds? What are their benefits? Just how risky
IBD conducted a virtual roundtable with Jacobs and three other
experts to find out.
IBD: Where can ETF investors look for income as bond
yields continue to fall short of expectations?
Jeff Beeson, product development manager at Invesco
PowerShares; $100 billion in assets under management:
Fixed-rate preferred securities have performed well amid recent
equity market and high yield turmoil. If rates are stuck at
current lows because economic growth is slowing, then preferred
securities may continue to deliver high income with more
"bond-like" returns than alternatives such as high yield and
Mike Dickson, director of structured financial solutions
at Horizon Investments in Charlotte, N.C.; $2.18 billion in
Overall we advocate tilting a portfolio towards more
equity-centric allocations to generate income from the larger
capital appreciation of the equity markets over time. A
well-managed income portfolio should resemble a "barbell"
investment strategy. Small allocations to low-volatility
short-duration bond ETFs should be used to provide liquidity as a
spending reserve, while larger equity and alternative allocations
should be used to generate capital appreciation and replenish
this spending reserve. Breaking down an income portfolio based on
volatility in this manner ensures investors can take withdrawals
even in down markets without locking in losses and having to sell
Jay Jacobs, director of research, Global X Funds; $2.7
billion in AUM:
The three areas that have historically delivered high yields to
investors outside of bonds are REITs, high-dividend stocks and
MLPs. Investors are also looking to emerging alternative income
spaces, like YieldCos.
Robert D. Williams, principal and managing director, Sage
Advisory Services; $11.9 billion in AUM:
ETF investors can draw from several alternative and
equity-oriented options that offer higher levels of income,
including preferred stocks, MLPs, and REITs. Additionally, there
are many equity-based high-dividend options including more
narrowly focused sector ETFs, such as utilities, as well as many
more broadly diversified options. Finally, for investors who want
to gain exposure across different markets in one vehicle, several
multi-asset income ETFs hold a combination of the above-mentioned
market segments (as well as fixed-income) in one ETF.
IBD: What benefits do alternative income sources bring
to a traditional equity-bond portfolio?
Investors are frustrated with a lack of income in traditional
fixed-income. They are looking to alternatives such as dividend
equities, high-yield debt, MLPs, bank loans and REITs. While
these generally offer higher income than aggregate-type exposure,
they can alter the overall risk profile of an allocation.
Investors should pay attention to how their alternative income
allocation is potentially tilting the scales toward more
equity-type risk for portfolios. That's why fixed-rate preferred
securities stand out among alternative income sources, with the
preferred market's higher correlation to the bond market.
Investors may also want to think more tactically about their
alternative income allocation, looking to rotate their risk
exposures based on their outlooks, needs and tolerances. For
example, MLPs have traditionally been a great source of
alternative income for investors, but have experienced excess
volatility over the last couple of years. A more tactical
approach to this space would have potentially rotated in and out
of this segment and helped individuals potentially avoid some of
Diversification benefits are the most uncontested benefits
offered by alternative income sources. As markets become more
globally interconnected and the ETF markets continue to grow, it
will become increasingly more difficult to truly diversify the
independent risk factors driving portfolio returns. Alternative
income sources provide exposure to more obscure areas of the
market, which are often driven by independent risk factors that
truly offer these elusive diversification benefits.
Besides diversification -- exposure to assets that have
historically low correlations to stocks and bonds -- alternatives
can also potentially offer higher yields because of unique tax
IBD: Which types of equity income and/or alternative
income ETFs do you use in your portfolios?
For equity income exposure, we like "smart beta" products such as
high-dividend and low-volatility ETFs, and less risky S&P
sectors such as utilities and consumer staples. These exposures
pay above-average yields and tend to outperform in choppy and
flat markets, like we have seen lately. For alternatives, we like
REITs and preferred ETFs for their yields, as well as how they
play together in a portfolio. Preferred ETFs offer equity
exposure but with lower volatility, while the low average
correlations of REITs with traditional assets can dampen their
equity-like volatility in a portfolio.
The universe of equity and alternative income ETFs that we
utilize are broken down into three categories:
- Non-core and hybrid fixed income: For example, PowerShares
Senior Loan (
) and iShares U.S. Preferred Stock (
- Traditional core, high-income equities: SPDR S&P
) is an example.
- Alternative and noncore equities: IShares Cohen &
Steers REIT (ICF) and Alerian MLP (AMLP) are examples.
IBD: Do the risks surrounding MLP, REIT and
high-yielding equity ETFs outweigh the tasty income?
Each of these asset classes is tied to unique considerations, but
one consistent theme across all would be the recent correlation
to oil and energy markets. If one believes we are poised for a
recovery in oil, these asset classes may have room for meaningful
recovery. But if oil is destined to bounce along these low levels
or even drop further, there may be more pain ahead for these
sectors, and investors may be rewarded to wait for a more
attractive entry point down the road.
The risks certainly can, but they don't have to. This is an area
that active management can add a lot of marginal value. Active
managers can help partition sources of volatility and minimize
unknowingly becoming exposed to risky areas of the market. For
example, MLPs suffered horribly over the past year due to the
unstable oil market. Active management can monitor risk and
hopefully avoid these types of drawdowns as the contagion
Alternatives, like REITs and MLPs, can have more concentrated
exposure to a particular sector than a broad equity or bond
benchmark. When real estate or energy markets are in a sell-off,
it can have a meaningful impact on those investments. It's key
for investors to diversify among these alternative income
sources, so they're not overexposed to one area.
Also, ETFs that target high-dividend
can be more broadly diversified by sector than MLPs or REITs, but
some strategies do not appropriately diversify risk across
individual holdings, meaning they are very top-heavy with high
weightings in just a few holdings. We believe that ETFs need to
emphasize diversification across high-dividend stocks to mitigate
stock-specific risks, while capturing the high yields that they
In certain periods, yes, the risk in these sectors relative to
traditional fixed-income options will far outweigh the additional
income. Investors must assess the overall purpose of the
portfolio, their risk tolerance and ability to withstand negative
performance. Understanding the risk or volatility of returns of
an asset vs. its income advantage to safer options is a key
There are periods where the margin of additional income is
slimmer and not worth the risk. Consider high spreads or income
advantage to Treasuries, for example. After the 2008 crisis, the
additional income advantage was over 15%, while entering 2015
this advantage had shrunk to under 5%. For fixed-income oriented
investors, adding non-fixed income requires even more caution,
considering that volatility of returns in MLPs and REITs can be
four to five times that of core fixed income. The drawdown in
these sectors in even short periods of a month or a quarter can
wipe out several years' worth of income advantage.
IBD: What are some equity income and alternative income
ETFs that investors may be overlooking?
PowerShares S&P 500 High Dividend Low Volatility Portfolio
(SPHD) has delivered returns far in excess of the S&P 500 and
over many large equity income peers during the past two years.
SPHD not only looks to high-dividend payers, but also screens out
many companies that may appear to pay a nice dividend but are
suffering from price instability. That has helped SPHD provide
strong returns, high income and low volatility that have really
stood out in this more volatile environment.
There are interesting value opportunities in
high-dividend-yielding stocks, as well as in the midstream MLP
space. Both areas are trading at wide spreads to 10-year
Treasuries and are at significantly lower valuations than they
had in 2014 and 2015.
Is generating income only an issue for the
In my opinion, no. Income is a crucial component to total
returns. Income can provide a stable backbone of returns
for a portfolio, offsetting fluctuations in market prices. Many
academic studies have highlighted the importance of dividends to
stock market total returns over time, suggesting that dividends
have historically played a greater role than price
During a sideways or declining market, income offers a unique
opportunity to serve as a ballast for many portfolios, continuing
to provide a potential source of returns. Income strategies,
sometimes viewed as a satellite investment, can be a part of a
core value-driven investment strategy for long-term investors,
not just retirees.
IBD: "Bonds are less risky." Agree or
Disagree. Bonds are less volatile than many assets classes, but
volatility is only one measure of risk. For example, we focus on
minimizing the likelihood of outliving one's money as a first
principle for retirees. Heavy allocations to bonds are very
exposed to this risk because bonds usually will not generate the
returns necessary to fund inflation-adjusted retirement spending
over time. We have found that while equities may have higher
volatility, they minimize this risk, along with inflation and
interest rate risk, by generating higher expected returns over
long horizons and outpacing most desired spend rates.
The question highlights a notable gap between how institutional
and retail investors think about risk. Institutional investors
tend to think "standard deviation," in which case bonds tend to
be far less risky. But retail investors tend to think "potential
for loss," and that's where the picture gets cloudier.
Right now, few are worried about interest rates spiking
higher, but if we ever enter a scenario of accelerated growth,
higher inflation and rising rates, then higher risk, as defined
by potential for loss, may shift over to bonds.
Retail investors may find a tactical approach to income an
appealing option given this heightened sensitivity to absolute
rather than relative returns. For example, a more tactical
approach may add or remove high-yield debt exposure based on when
it may be a more opportune time to own it.
While low duration, low (or no) credit risk bonds can be very
stable day to day, longer-dated, higher-yielding bonds can have
equity-like levels of volatility. There is no "one-size-fits-all"
assumption for risk when it comes to bonds, equities or
From the perspective of stability of returns, larger drawdown
risk and overall volatility, core bonds are less risky for
investors. The desire for income as a priority in a portfolio
implies a more conservative risk tolerance and the desire for
some return stability. Given this view, we believe investors
should tap into the wide assortment of income options available,
but maintain a core of traditional fixed income. Alternative
income options can replicate the consistent income of traditional
bond allocation, but they cannot replicate the volatility of a
core bond portfolio in a bear market.
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