By Patricia Oey
Investors' quest for income has been a well-documented trend during the past year. From January to November, some of the top Morningstar categories for open-end fund flows have been intermediate-term bond, high-yield bond, and emerging-markets bond. More recently, there have been relatively strong flows into allocation funds. Fund flows into exchange-traded funds have followed a similar pattern, with strong flows into bonds (long, intermediate, and high-yield) and to a lesser degree, large-value, which includes many dividend-oriented funds.
Allocation ETFs are still small in number and have not attracted much investor attention. But in 2012, four allocation, multiasset income-focused funds have launched. These ETFs, as one-stop funds for diversified income exposure, seek to address investors' need for higher and potentially more stable income.
The goals of multiasset income funds typically include the following: (1) high income--currently around 5%, (2) long-term capital appreciation, and (3) preservation of principal through diversification and lower volatility.
To accomplish these goals, these funds invest across a number of "income" asset classes, such as U.S. and foreign dividend-paying equities, preferred stock, REITs, master limited partnerships, high-yield bonds, and emerging-markets debt. These can be rules-based passive funds or actively managed funds. Multiasset income strategies have been available as separately managed accounts for high-net-worth individuals and institutions, but with the launch of four new ETFs, there are currently six multiasset ETFs (details follow) now available to any investors with a brokerage account. Investors should note that these funds can be very different from one another and, depending on their fixed-income exposure, may be categorized as either an equity fund or an allocation fund.
The diversification benefit from the multiasset approach can help reduce interest-rate risk associated with long-term bonds, market sensitivity of value stocks, and credit risk of high-yield bonds. While these funds (or their underlying indexes) have a track record of a only few years, so far, they have generally provided higher income and slightly higher risk-adjusted returns when compared to the average of their respective Morningstar categories. However, it is important to note that REITs, MLPs, high-yield debt, as well as U.S. equities, all declined more than 30% in 2008, which suggests that these assets may not provide diversification "benefits" when you need it most.
These funds could be attractive to income-oriented investors who tend to be more overweight traditional income securities, such as utilities, and safer lower-yielding bonds. These products also provide exposure to higher yielding energy MLPs without the tax complications. If a multiasset fund limits its MLP assets to less than 25% of its portfolio, it is able to pass through most of the MLP distributions to shareholders as return of capital or ordinary income without K-1 statements. This is more convenient than holding individual MLPs, where shareholders are considered limited partners and receive K-1 statements. MLPs exchange-traded products also have some cumbersome characteristics: All MLP ETN distributions are taxed as ordinary income, and these products carry credit risk. MLP ETFs are taxed twice, once at the fund level and then at the shareholder level, which drags on overall returns.
Distributions from the other asset classes will usually maintain their tax treatment. In other words, most dividends from equity and preferred holdings will be considered qualified (subject to holding period rules), and most distributions from fixed income and REITs will be taxed at ordinary rates (some REIT distributions might be classified as return of capital). Should Congress allow the Bush tax cuts to expire at the end of the year, all dividends will be taxed at ordinary (and higher) income tax rates. Investors holding dividend equity funds in taxable accounts might find multiasset income funds a more attractive substitute next year should the tax cuts expire.
The Two Oldest Multiasset Income ETFs
Guggenheim Multi-Asset Income (CVY) is currently yielding about 5.2% with half the portfolio in U.S. equities and the remainder primarily in foreign-equity ADRs, REITs, MLPs, and closed-end funds. It is a passive fund that tracks the Zacks Multi-Asset Income Index, a yield-oriented index that employs company-growth and yield-growth screens to sift out lower-quality names. This ETF and its sibling Guggenheim International Multi-Asset Income (HGI) (more details follow) are the two options (of the six) with no fixed-income exposure. This ETF is somewhat more volatile than the S&P 500, but during the past five years it has provided better risk-adjusted returns, with a five-year Sortino ratio of 0.39 versus 0.19 for the S&P 500. It has also provided better-than-average risk-adjusted returns relative to its Morningstar large-value category. That said, this ETF did decline 41% in 2008. On its website, Guggenheim provides historical tax information for CVY's distributions. During the past few years, about 50% of the distributions were qualified, and about 20%-30% were classified as a return of capital (collected from its MLP and REIT holdings), which is not taxable until the sale of the fund, when it will reduce the shareholders' cost basis. This ETF was launched in September 2006.
Guggenheim International Multi-Asset Income has a similar strategy as CVY except that it has more of a global focus, which includes emerging-markets securities. Its index, Zacks International Multi-Asset Income Index, seeks to provide better risk-adjusted returns than the MSCI EAFE Index, which it has since its inception in July 2007. This ETF has also provided better-than-average risk-adjusted returns relative to its Morningstar foreign large-value category. This ETF's yield is 4.3%, which is net of foreign tax withholding. Investors who hold this ETF in a taxable account will be able to use tax credits for the foreign taxes paid.
One Active Option
SPDR SSgA Income Allocation ETF (INKM) is currently the only actively managed option. It is managed by SSgA's Investment Solutions Group, which runs a similar strategy for its institutional clients. The team employs quantitative models and fundamental analysis to select asset classes, focusing first on total return and then yield. INKM is an ETF of ETFs, and typically holds around 20 ETFs. The portfolio's asset-weighted yield is about 4.5%, but the actual yield will be reduced by a portion of INKM's 0.70% expense ratio. (This 0.70% includes the fees of the ETF and the expense ratios of the underlying ETFs.) This ETF has a 35% targeted exposure to investment-grade bonds, which should make INKM less volatile than CVY and HGI. However, the managers can over- and underweight between 1% to 20% relative to its target exposures, which are equity (35%), investment-grade bond (35%), global real estate (10%), high-yield bonds (10%), and hybrids (10%). One potential benefit of active over passive is that the manager can quickly move the portfolio to lower-risk securities during periods of high market volatility.
The Conservative-Allocation Option
iShares Morningstar Multi-Asset Income (IYLD) is considered a conservative-allocation fund because of its targeted 60% weighting in fixed-income securities. (Morningstar licenses IYLD's index to BlackRock and earns asset-based fees.) This ETF's underlying index, Morningstar Multi-Asset High Income Index, has had a three-year annualized standard deviation of returns of 4.9% and a Sortino ratio of 6.5. However, we note that at this time, it has a high 20% weighting in a high-yield bond ETF. Other top exposures include preferred stocks (10%), U.S.-dollar-denominated emerging-markets bonds (11%), and long-term Treasuries (15%). Securities in the index are selected according to a proprietary Morningstar mean variance optimization equation, which employs return, standard deviation, correlation, and yield data. We estimate the yield of this ETF to be around 5%. Like INKM, IYLD is an ETF of ETFs, and its 0.60% expense ratio includes both the fees for the fund and the fees for the underlying ETFs.
The Moderate-Allocation Option
First Trust Multi-Asset Diversified Income Index (MDIV) is somewhat more risky than IYLD, as its 35% fixed-income allocation is composed of preferred securities and high-yield securities. The remainder of the fund is in U.S. equities, REITs, and MLPs. We estimate the yield of this fund's underlying index to be around 7%, and its expense ratio is 0.60%.
The High-Yield and Likely High-Risk Option
Arrow Dow Jones Global Yield ETF (GYLD) tracks an index composed of five equally weighted subindexes of five different asset classes--global equity, global real estate, global corporate debt, global sovereign debt, and global alternative (which includes energy-related preferred stocks, MLPs, and Canadian royalty trusts). These subindexes are each composed of 30 equal-weight securities selected for yield, subject to certain quality and liquidity screens. The index's current yield is around 7%, which will be reduced by GYLD's 0.75% expense ratio. This ETF is in the Morningstar world-allocation category, and significant weightings include 60% in foreign securities, 44% in non-U.S.-dollar-denominated securities, 28% in financials-sector securities, and the majority of the 40% allocation in fixed-income in non-investment-grade bonds. We expect this ETF's volatility to be close to that of a broad domestic-equity fund.
A version of this article appeared June 6.
Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.