We utilize a bucketing strategy but it is not the retirement strategy you may know.
We think minimizing sequence of returns risk and 'fixing' the 60/40 portfolio is a necessity.
Overall, fixed income is likely to be an Achilles heel for many investors and advisors alike.
A bucketing strategy to asset allocation during retirement has become very popular with many investors and advisors. However, we think the benefits of such an investment approach are largely psychological. Delineating spending buckets by time frame, we believe, is more organizational and allows 'clean thinking' of where to pull assets from during different time periods.
When we discuss our bucketing strategy, we are not referring to this well-known bucketing approach to retirement. Instead, we are talking about how we segment our assets for income production and risk.
We recently published a piece on how advisors will need to do something different in the future. Most have simply relied on a 60/40 portfolio allocation for their clients which worked wonderfully during a 35-year bull market. However, given that interest rates have likely reached their nadir and will trend higher from here we think the portfolio construction technique will be flawed.
Our marketplace service has three primary buckets (or portfolios):
- Safe Bucket: Cash and cash equivalents. This is dry powder to be used either for retirement spending during downturns or to reduce risk of the overall portfolio.
- Core Income Portfolio: Our bread and butter income portfolio. We favor high current income over "dividend growth". We believe positioning our fixed income portfolio for the best risk-reward with higher yields to be reinvested opportunistically presents us with lower sequence of returns risk. This is our no-withdrawal investment approach.
- Peripheral Portfolio (Strategic Income Portfolio): This is where most of our members customize their portfolios for their given needs and risk tolerances. The type of assets in this segment can run the entire spectrum of risk.
Historically, bonds have provided portfolio defense during times of financial stress. We have discussed with our membership that we believe the way financial advisors and investors structure portfolios will be flawed going forward. Instead, investors have moved up the risk spectrum in order to meet their return hurdles- the rate of return assumption for their retirement plans to 'work'.
We met one advisor who maintained an 80/20 mix for all clients including those in retirement. His basis for such an allocation was that 'bonds offered nothing' and stocks were the place to be. He also cited the oft-touted interest rates are going up thinking that has been commonplace for the last 7 years. And wrong.
But is the answer to simply add more risk to the portfolio to improve the return? Especially given that we are 9 years into a bull market where the S&P500 has risen by ~300% from the bottom.
We like to always have a pool of assets for investing- whether it is for spending needs during downturns or to take advantage of acute opportunities in various assets we follow.
Today, the bucket is no longer a massive drag on your overall portfolio. The 2-year treasury note now yields above 2.5%. 1-month libor is also above 1.93% today. The yield was below 0.10% just a couple of years ago. Cash is no longer trash.
Ultra-short treasuries are just one component that can be used in this part of your portfolio. The growth of ETFs in recent years and the amount of niche asset classes can help you create a diversified and very safe portfolio.
Here we use both open-end funds and ETFs for our exposures with the riskiest asset being a small allocation to SPDR Gold Shares- (GLD). In a recent blog post, we also highlighted an actively-managed ETF run by PIMCO- (MINT). The net yield on the fund is 1.69%. Another option is PowerShares Ultra-Short Duration ETF- (GSY) with a net yield of 1.93%. These are our cash substitutes today as most brokerage money markets still pay far less than 1% on their deposits.
For those that are still a decade or more from retirement, an overfunded life insurance policy can provide one of the best returns per unit of risk assumed. A mutual insurer (Northwestern, NY Life, MassMutual, Guardian) can provide a tax-deffered vehicle for safe money. Permanent insurance has a cash value build-up that is highly liquid even allowing the owner of the policy to take out loans against it. Most insurers today offer up a dividend rate that is between 4.5% and 7% with no risk of the cash value declining. In 2008, most dividend rates were between 6% and 9%.
Other options include:
- High interest savings, especially from credit unions
- Safe mutual funds- we have many favorites here.
The Core Portfolio
This is a our income portfolio that aims to hit singles and doubles. We believe the paycheck functionality of the approach is superior, especially for investors who are in retirement. If you need to draw income from your portfolio, a current yield of nearly 8% allows you significant cushion to NAV declines and volatility. The Core Portfolio primarily uses closed-end bond funds, as when we launched our marketplace service, the discounts were at one of the widest in history. Today, discounts have tightened substantially but are still around their long-term averages.
Current positioning is primarily in closed-end bond funds with a keen eye on interest rate and credit risks. Balancing these risks is a key feature of the portfolio though we are currently skewed towards an overweight to credit- while we like the higher quality (and lower yielding) segment of that market better today.
Closed-end funds (CEFs) carry more risk (volatility) as compared to open-end bond mutual funds and individual bonds. So we typically like to see investors "take" from the equity portion of their allocation just as much as from their fixed income. But we feel volatility on price in CEFs provides us with opportunity and that the true measure of volatility on these structures should be done on NAV movement.
What we want to build is a portfolio the withstands these draw-downs while earning us the income we need and desire. We may not keep up during those melt up periods like we saw in the first four weeks of January but avoiding the large corrections or bear markets (when it comes) is imperative in our strategy.
Sequence of returns risk is the initiation of drawing on your portfolio and then experiencing a large decline in portfolio value early in your retirement years. When withdrawing from an investment portfolio the impact is an increase in portfolio volatility. Think of retiring in 2007 and the next year seeing your retirement nest egg decline by 25-35% or more. At the same time you are pulling out an annualized 2-4% of the portfolio's value to meet your lifestyle needs. The result is a permanent impairment of your capital.
On the other hand you have accumulators who are still working and have at least 7 years before they are due to retire. For those with much longer time horizons, there is a decision to be made. Either they accept the equity risk and shift their portfolios away from low-yielding bonds or they can accept lower rates of returns. But our accumulator members are using our strategy for their fixed income allocation keeping their 60-40 to 80-20 stock-to-bond asset mixes but improving that bond return.
Remember, the long-term return for a bond portfolio typically ends up being the starting yield of when you acquired the shares. If you buy an investment grade bond fund yielding 3.75%, then your long-term total return is likely to be very close to 3.75%. Improving on that return figure is one of our primarily solutions for members.
We currently have a max allocation to the Core of 35%. This is down from 40% which we moved to in December and down from 60% nearly 3 years ago. Leverage costs are the main reason for the decline in the allocation. Ideally, we would max the core at the projected annual income needed or 35%, whichever is greater.
This is where members can customize their portfolios for their risk and return objectives. For the highly risk averse, this means reducing risk by adding safe-rated investments (we rate all of our securities 1-5, one being the safest, five the riskiest). For younger investors, this is where they add their equity exposure to produce long-term wealth accumulation.
We like using a few core mutual funds and ETFs for our growth equity exposure augmenting it with various individual securities. For investors that need additional yield, we like to use high yield equities which we look at from a high yield bond perspective- the ability to provide high current income and a return of capital.
Our Strategic Income Portfolio is a subset of the Peripheral where we build a diversified portfolio of investments we discuss in our weekly commentaries. These are mostly closed-end funds but may also include mutual funds, preferred stocks, baby bonds, and some dividend paying stocks. The primary security type is the closed-end fund which we believe is the last bastion of severe inefficiency in the markets today. This stems from the lack of institutional investors- for the most part- in the space.
We have some "buy and hold" ETFs and mutual funds to gain us exposure to areas of the market we think are favorable long-term. While we are of the camp that NO INVESTMENT is a buy-and-hold, we want to keep trading to a minimal level.
Our secondary goal is take advantage of confluence trades with discounts reverting to the mean. Many funds inexplicably see discount widening that are anomalous compared to their historical averages. We also have done extensive research on the moves of fund prices after a distribution cut.
Just two months ago, the shares of PCI were trading at a 7%+ discount as the market was reeling from interest rate spike fears. We have noted many times in the past that the CEF marketplace is the ultimate sentiment indicator for interest rates. Any sniff of higher rates tends to send these largely retail investors running for the exits and the lower-liquidity of the space compounds the move. CEFs tend to get hit twice from a shift up across the entire yield curve. First, from the higher leverage costs and second from the long-maturity rates depressing the values of the underlying holdings.
We advised members of our marketplace to overweight PCI at that point given what we saw was an anomaly. The fund had been up nicely since the start of the year with the NAV up 4 cents after extracting out over 32 cents for distributions. In other words, investors were selling off this fund despite the YTD NAV return being UP 1.35%.
By going against sentiment and buying funds that we think are at anamolous discounts to NAV, we think we have reduced our downside while potentially increasing our upside.
The Bottom Line
If you have a 60/40 portfolio, that 40% is likely to provide you little value over the next decade. If you move to 80/20, then you may be accepting much higher volatility than you may be comfortable with causing you to sell at just the absolute wrong time.
Our marketplace service is geared towards helping advisors and investors alike create a diversified portfolio of securities that generate a stronger current income stream. We are seeing more financial advisors look to solve their problems through our service. For the next few days, you have a rare opportunity to try it out for free and then get a 15% discount if you sign up.
The utilization of our Core Income Portfolio as the centerpiece of their fixed income strategy fits nicely in all asset allocations from 80/20 portfolios (80% stocks, 20% bonds) to 0/100 (all bonds). The Core simply fits into the fixed income sleeve for a portion of those assets.
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Yield Hunting: Alternative Income Opportunities
Alpha Gen Capital started Yield Hunting in April 2016 with one purpose in mind: to find yield in a yieldless world. While some subscription services will find yield at any cost, we pride ourselves on the fact that our core portfolio can generate a roughly 8% yield while exposing investors to one-third the risk of the S&P 500.
We utilize fixed income and specialty CEFs, dividend-paying stocks, munis, BDCs, baby bonds, among other investment vehicles to generate income while mitigating the risk on the downside from adverse and identifiable risks.