Time for Advisors to Focus on Income Funds?
As we experience the last act of this equity bull market, advisors are looking for places to protect client funds with a potential of earning returns greater than that available from cash equivalents. As the chart below indicates, consumer prices (in red) are growing at a faster rate than can be earned in short-term instruments (in blue). Those saving for or in retirement must earn positive real (or inflation-adjusted) returns to maintain security in volatile markets.
Income-oriented funds shine in difficult markets
Historically, income-oriented funds have performed well in flat to down stock markets. Usually, the bond portion of the strategy rise in prices as interest rates drop during these times. In addition, the high dividend stock portion of the funds earn better results than other equities in bear markets. The chart below shows that in the 2000-2001 and 2007 -2009 timeframes, high dividend stocks significantly outperformed growth stocks.
High Dividend Stocks Provide Protection in Negative Equity Environments
High Dividend Stock Total Return minus Growth Stock Total Return
The problem with most income funds is that they are not well-diversified. Historically, they have been overweighted in high dividend stocks and high yield bonds, as indicated by the chart below.
Concentrated sources of income in most income-focused funds
Average Percentage Allocation 4/1/2006 to 3/31/2016
The problem with high dividend stocks is that they tend to be concentrated in a few sectors. At an extreme, the Global X SuperDividend U.S Exchange Trade Fund has a 6.7% current yield. But as of 6/30/2018, over 60% of the holdings are in financial, utilities, and energy stocks.
Although high yield bonds have low correlations with government bonds, they have moderate correlations with equities. The chart below indicates that over the long-term, U.S. high yield bonds (“US junk bonds”) have had higher correlations than all other traditional asset classes except corporate bonds. In other words, high yield bonds act more like stocks than investment grade bonds, especially Treasuries. Therefore, if you have a portfolio with a greater than 75% allocation to stocks and high yield bonds (as indicated in the previous income fund allocation chart), you will significantly participate in the next market downturn.
Junk Bonds Act More Like Stocks Than Bonds
Correlation matrix of nominal returns from 1976 through 2016
Source: Engineered Portfolio.Com
Optimal Income Portfolio Construction
Given the pitfalls previously identified in investing in an income fund, the following should be present in an income portfolio in which it is worth investing:
- Portfolio current yield high enough to receive significant income to offset losses (currently, that would be greater than 5%).
- Most of the holdings experience low to moderate correlation to broad equity indices to increase diversification from stocks during down markets.
- The holdings have a low to moderate correlations to each other to reduce concentration of risk in the portfolio.
- Historical indications of positive alpha for the portfolio risk being incurred.
For the six months ending 8/17/2018, the following sectors would make good holdings in such a portfolio (this is not a recommended portfolio – just a list of sectors to be considered):
Sources: ETF Screen.Com, Morningstar
Financial advisors and their clients can receive a portfolio based on the recommendations above by investing in an iSectors® Endowment Allocation separately managed account. The objective of the strategy is to earn high current income while preserving capital. High total return is a secondary objective. The current portfolio has 16 holdings that are well diversified from the equity market and each other. Equities represent 54% of the portfolio and fixed income 46%. The equity portion is exposed to U.S., developed market and emerging market holdings. U.S. high yield constitutes only 15% of the portfolio with other fixed income sectors such as preferred stocks, business development corporations, and floating rate sectors represented. The current yield of the portfolio is 5.4%.
Reviewing historical statistics, we expect that this portfolio will have a beta close to that of the 54% MSCI All Country World/46% Citi World Government Bond blended index while returning a positive alpha. Compared to the ACWI, the beta is nearly one-half of the benchmark, with a positive alpha. Past performance is not indicative of future returns.
You will find further information about the iSectors Endowment Allocation described above here on our website https://isectors.com/.
Individual investors can contact Scott Jones for a referral to a recommended iSectors advisor that can help them determine the best iSectors asset allocation for their portfolios.
Also be sure to listen to our latest eposide on the iSectors Selections Podcast to learn even more about iSectors’ Endowment Allocation. Vern Sumnicht and I discuss all of above in even greater detail.