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What Your Advisor Hasn’t Told You About Income Investing, A Q & A
One of the biggest mistakes investors make is ignoring the “income purpose” part of their investment portfolios…many don’t even realize there should be such a thing. The second biggest mistake is to examine the performance of income securities in the same way that “growth” securities (stocks) do.
The following questions and answers assume that portfolios are built around these four major minimizers of financial risk: All securities meet high quality standards, produce some form of income, are “classically” diversified, and are sold when a “reasonable” target profit is achieved.
1. Why should a person invest for income; Aren’t stocks much better growth mechanisms?
Yes, the purpose of equity investments is to produce “growth,” but most people think of growth as an increase in the market value of the securities they own. I mean growth in terms of the amount of new “capital” that is created through the realization of profits, and the compounding of earnings when that new capital is reinvested using “cost-based” asset allocation.
Most advisors don’t look at profits with the same warm and fuzzy feeling that I do… maybe it’s the tax code that treats losses more favorably than gains, or the legal system that allows people to sue advisors if they subsequently look at the wrong path they may have taken. Truth be told, there is no such thing as a bad salary.
Most people would not believe that, over the past 20 years, a 100% income portfolio would have “outperformed” all three major stock market averages in “total return”… using such a conservative annual distribution number of 4% : Percentage Annual Gains:
NASDAQ = 1.93%; S & P 500 = 4.30%; DJIA = 5.7%; 4% of the closed-end fund portfolio (CEF) = 6.1%
*NOTE: over the past 20 years, taxable CEFs have actually returned around 8%, net of taxes, just under 6%… and there were all the capital gains opportunities from 2009-2012.
Try looking at it this way. If your portfolio is generating less income than you are withdrawing, something must be sold to provide money for spending. Most financial advisors would agree that you don’t need less than 4% (paid in monthly amounts) in retirement… regardless of travel, grandchildren’s education, and emergencies. Only this year, most of that money had to come from your principal.
Similar to a basic fixed annuity plan, most retirement plans assume annual principal reduction. A “retirement-ready” income plan, on the other hand, leaves principal to heirs while increasing the annual spending money for retirees.
2. How much of an investment portfolio should be focused on income?
At least 30% for everyone under 50, then increasing allocations as retirement gets closer…portfolio size and spending requirements should dictate how much of the portfolio can be exposed to stock market risk. Usually no more than 30% in shares for retirees. Very large portfolios might be more aggressive, but isn’t real wealth the knowledge that you no longer have to take significant financial risks?
As an additional added safety measure, all equity investments should be in investment grade stocks and a diversified group of equity CEFs, ensuring cash flow from the entire portfolio, all the time. But the key from day one is to make all asset allocation calculations using the cost basis of the position instead of market value.
NOTE: When stock prices are very high, equity CEFs provide significant income and excellent diversification in a managed program that allows participation in the stock market with less risk than individual stocks and significantly higher income than even income mutual funds and income ETFs.
Using total “working capital” instead of current or periodic market values, allows the investor to know exactly where to invest new additions to the portfolio (dividends, interest, deposits and trading income). This simple step ensures that the portfolio’s total income increases year after year and accelerates significantly toward retirement as the asset allocation itself becomes more conservative.
Asset allocation should not change based on market or interest rate predictions; projected income needs and minimizing the financial risk of retirement readiness are primary concerns.
3. How many different types of securities exist, i
There are a few basic types, but there are many variations. To put it simply, and in ascending order of risk, there are US government and agency debt instruments, state and local government securities, corporate bonds, loans and preferred stocks. These are the most common varieties and generally provide a fixed level of income that is paid semi-annually or quarterly. (CDs and money market funds are not investments, their only risk is a type of “opportunity”.)
Variable income securities include mortgage products, REITs, unit trusts, limited partnerships, etc. And then there is a lot of incomprehensible speculation created by Wall Street with “traunches”, “hedging” and other strategies that are too complicated to understand . .to the extent necessary for prudent investment.
Generally speaking, higher yields reflect greater risk in individual income securities; complicated maneuvers and adjustments increase the risk exponentially. Current yields vary depending on the type of security, underlying quality of the issuer, time to maturity, and in some cases, industry conditions… and, of course, the IRE.
4. Hhow much do they pay?
Short-term interest rate expectations (IRE, aptly), mix up the current yield pot and keep things interesting as yields on existing securities change with “inversely proportional” price movements. Yields vary widely by type and currently range from under 1% for risk-free money market funds to 10% for oil and gas MLPs and some REITs.
Corporate bonds are around 3%, preferred stocks around 5%, while most taxable CEFs generate close to 8%. Tax-free CEFs yield about 5.5% on average.
Quite a wide range of earning opportunities, and there are investment products for every imaginable investment type, quality level and investment duration… not to mention global and index opportunities. But without exception, closed-end funds provide significantly more income than ETFs or mutual funds…not even close.
All types of individual bonds are expensive to buy and sell (bond upgrades and new issue preferences do not need to be announced), especially in small amounts, and it is virtually impossible to add to bonds when prices fall. Preferred stocks and CEFs behave like stocks and are easy to trade as prices move in either direction (ie, easy to sell for a profit or buy more to reduce cost basis and increase yield).
During the “financial crisis”, CEF yields (tax-free and taxable) almost doubled…almost all could be sold multiple times, at a “one-year forward interest” profit, before returning to normal levels in 2012.
5. How do CEFs produce these higher levels of income?
There are several reasons for this large difference in returns for investors.
CEFs are not mutual funds. They are separate investment companies that manage a portfolio of securities. Unlike mutual funds, investors buy shares in the company itself, and there are a limited number of shares. Mutual funds issue an unlimited number of shares whose price is always equal to the net asset value (NAV) of the fund.
CEFs are priced by market forces and can be above or below NAV… so they can sometimes be bought at a discount.
Income mutual funds focus on total return; CEF investment managers are focused on creating money for consumption.
CEF raises money through an IPO and invests the proceeds in a portfolio of securities, most of which will be paid out in the form of dividends to shareholders.
An investment company can also issue preferred stock at a guaranteed dividend rate significantly lower than what it knows it can get in the market. (eg they could sell a 3% callable preferred stock issue and invest in bonds that pay 4.5%.)
Ultimately, they negotiate very short-term bank loans and use the funds to buy long-term securities that pay a higher interest rate. In most market scenarios, short-term rates are much lower than long-term rates, and loan durations are as short as the IRE scenario allows…
This “leveraged borrowing” has nothing to do with the portfolio itself, and in times of crisis, managers can stop short-term borrowing until a more stable interest rate environment returns.
Consequently, the actual investment portfolio contains significantly more income-generating capital than that obtained from IPO proceeds. Shareholders receive a dividend from the entire portfolio. Read my article “Investing Under The Dome” for more.
6. What About Annuities, Stable Value Funds, Private REITs, Income ETFs, and Retirement Mutual Funds
Annuities have several unique features, none of which make them good “investments.” They are great security blankets if you don’t have enough capital to generate adequate income on your own. The “variable” variety adds market risk to the equation (at some additional cost), subverting the original principles of the fixed amount annuity.
They are the “mother of all commissions”.
They charge penalties that effectively lock up your money for up to ten years, depending on the size of the commission.
They guarantee a minimum interest rate that you get while paying your own money back over your “actuarial life” or your actual life, whichever is longer. If you get hit by a truck, the payout stops.
You can pay extra (ie reduce your payments) to help others or to ensure your heirs get something when you die; otherwise the insurance company gets the entire balance regardless of when you opt out of the program.
Stable value funds guarantee you the lowest possible return you can get in the fixed income market:
They include bonds with the shortest durations to limit price volatility, so in some scenarios they could actually yield lower returns than money market funds. Those with slightly higher paper yields include an insurance “wrap” to ensure price stability, at additional cost to the annuitant.
They were built to reinforce Wall Street’s misguided emphasis on market value volatility, the harmless and natural personality of interest-rate sensitive securities.
If money market rates ever return to “normal,” these bad joke products will likely disappear.
Private REITs are the “daddy of all commissions,” illiquid, arcane portfolios, far inferior to publicly traded varieties in many ways. Please take the time to read this Forbes article: “Investment Picks to Avoid: Private REITs” Larry Light.
Income ETFs and retirement income mutual funds are the second and third best ways to participate in the fixed income market:
They provide (or price track) diversified portfolios of individual securities (or mutual funds).
ETFs are better because they look and feel like stocks and can be bought and sold at any time; the obvious downside of most is that they are built to track an index, not generate income. A few that seem to produce above a measly 4% (just FYI and absolutely not a recommendation) are: BAB, BLV, PFF, PSK and VCLT.
In terms of retirement income mutual funds, the most popular of all (Vanguard VTINX) has an equity component of 30% and yields less than 2% in actual cash outlay.
There are at least a hundred “seasoned” tax-free income CEFs and forty or more equity and/or balanced CEFs that pay more than any ETF or income mutual fund.
More questions and answers in the second part of this article…
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