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- dividend stocks . 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 category.
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 date.
So what are all the ETF strategies that investors can use to find income beyond bonds? What are their benefits? Just how risky are they?
IBD conducted a virtual roundtable with Jacobs and three other ETF investing 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 MLPs.
Mike Dickson, director of structured financial solutions at Horizon Investments in Charlotte, N.C.; $2.18 billion in AUM: 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 losing positions.
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?
Beeson: 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 this volatility.
Dickson: 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.
Jacobs: 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 incentives.
IBD: Which types of equity income and/or alternative income ETFs do you use in your portfolios?
Dickson: 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.
Williams: 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 ( BKLN ) and iShares U.S. Preferred Stock ( PFF ).
- Traditional core, high-income equities: SPDR S&P Dividend ( SDY ) 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?
Beeson: 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.
Dickson: 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 spreads.
Jacobs: 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 stocks 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 offer.
Williams: 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 question.
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?
Beeson: 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.
Jacobs: 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.
IBD:Is generating income only an issue for the retirement-minded investor?
Beeson: 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 appreciation.
Jacobs: 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?
Dickson: 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.
Beeson: 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.
Jacobs: 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 alternatives.
Williams: 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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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.