By Samuel Lee
We all want income. But when lots of people desire the same object, it often ends up in the hands of those willing to be the most foolish and reckless. An example of yield-grabbing gone wrong is how investors have bid up the price of closed-end fund PIMCO Global StocksPLUS & Income (PGP) to a 63% average premium over the past six months. You can get the same expertise and a competitive yield for a fair price through PIMCO's mutual funds. This madness should give us pause. At what price income?
Investors should acknowledge that income is not the goal. The goal is to grow your assets in a manner consistent with your needs. Why, then, am I even writing about harvesting income? Why not just write about how to make money? Because the market is at turns greedy, acquisitive, overconfident, envious, and fearful--sometimes all at once. Because it favors the quick buck over the steady dividend. Because I think boring is beautiful. In other words, income-producing assets are often underpriced. Boring, high-yielding stocks have, over long periods, done better than low- and no-yielding ones in almost every stock market studied, and with lower volatility. I love income to the extent that it signals a good deal. The irony is that today some high-income asset classes have become the flavor du jour.
The Theory of Yield Relativity
The scramble for yield is the understandable outcome of years of rock-bottom interest rates. But understandable doesn't mean sensible. I believe the biggest mistake in income investing is targeting a yield level. When yields are low, you have to stretch into junkier assets to reach your goal. Prospective reward may go up, but risk goes up faster because other investors are also piling into the same assets and driving up prices. At a certain point, risk rockets up to the point where each additional point of yield actually leads to a significant chance of ruin. Schwab YieldPlus was an ultrashort bond mutual fund that had among the highest yields in its category. It was sold as an enhanced money market fund substitute, a safe way to add a little juice to your cash. It lost 37% in 2008 and 10.5% in 2009. And for what? A measly 1% yield over cash.
Why is this? I think a big reason is the misalignment of interests between fund managers and investors. Fund managers (or bankers) who top their peers--even if by only a little bit--are hailed as geniuses and collect fat bonuses. But if they blow up their funds (or banks), the checks they cashed in good times don't get clawed back. This motivates some unscrupulous managers to run the most risk possible, often with as much hidden leverage as possible, because they get all the upside and little of the downside. As a consequence, the riskiest (and often, the highest-yielding) stuff can become grossly overpriced.
Doing Yield Right
Avoiding the garbage does mean sacrificing yield. This may seem unacceptable to some investors, who need a certain yield level to sustain their expenditures. That's dangerous thinking. At times the market won't offer reasonable yields above Treasuries. Stretching for yield at such times lures you into venturing beyond your risk tolerance--a truly devastating outcome, if you end up panicking and selling out at a bottom. Figure out your risk tolerance first, then construct the portfolio that maximizes return. Doing yield right isn't just about finding the most attractive yield opportunities today, but also being disciplined enough to walk away when the prospective rewards aren't rich enough. It's a continuous process, not a magic-bullet portfolio of hot picks right now.
I've put these ideas to work in ETFInvestor's ETF Income Portfolio, which attempts to beat Treasury bills by 5% with the lowest risk possible. The absolute return mandate frees me to invest with full conviction in asset classes that I feel have the best valuations. It's staked with about $140,000 of Morningstar's capital, and I have a big chunk of my retirement funds in it, too.
The bad news is that yield is expensive right now. Because rates have stayed low for a really long time and look set to stay low, investors have gotten a bit desperate and pushed up valuations of high-yielding assets to lofty heights. I believe patience will likely be rewarded down the line with buying opportunities. Consequently, in every asset class, barring already-sedate intermediate-term bonds, I own lower-volatility funds. In the past, low-volatility strategies have offered about as high a return as whatever asset classes they're applied to, sometimes even more. This finding has been true in junk bonds, U.S. stocks, and international stocks. They tend to have above-average yields (the 12-month trailing yields of the EAFE and emerging-markets low-volatility ETFs I've chosen are unusually low, but I believe they're artificially depressed because of their newness). In addition, the portfolio's asset allocation is defensive, with about 52% in fixed income and 9% in cash.
Most of my fixed income is in PIMCO Total Return ETF (BOND). Its yield to maturity is about 2 percentage points more than the Barclays Aggregate Bond Index. With BOND, I can reasonably expect positive real returns, something I can't do with the Barclays bond index. I'm not expecting miracles from Bill Gross and company. Since inception, the mutual fund PIMCO Total Return (PTTRX) has beaten its index by about 1% annualized--no mean feat in the brutally efficient liquid bond markets. However, they've done a good job anticipating major central-bank policy moves, earning the fund unusually high returns in 2009 and 2012.
On the equity side, I'm light on the U.S. stock market. It yields only 2% and has a cyclically adjusted price/earnings ratio of 21, about 40% higher than its historical average. The market looks cheap if you trust forward earnings estimates. I don't. Wall Street analysts have in the past systematically projected higher earnings than are realized, and they tend to over-extrapolate from recent trends, ignoring earnings' tendency to revert to the mean. At 11% of GDP, U.S. corporate profit margins are the highest they've ever been since the government started collecting statistics in 1947. Much of it has to do with declining taxes as a share of profits. Also, deficit spending has kept aggregate demand up, despite a brutal job market that has allowed businesses to slash jobs and wages. Rising corporate taxes or a recovering labor market will probably hurt profit margins over the long run.
I still have exposure to U.S. equity markets through junk bonds, which behave half like equity and half like bonds. They're trading at average valuations, but shorter-maturity junk bonds offer competitive yields to longer-maturity bonds, and with lower credit risk. The highest-yielding junk bonds do offer 10%-plus yields, but if you assume historical default rates will hold true, they offer scant or even negative expected excess returns.
Finally, I think some of the biggest yield opportunities are in emerging markets. They're young, relatively free of debt, fast-growing, and reasonably priced. Emerging-markets dividend stocks offer yields around 4%-5%. In a world where cash yields negative 2% after inflation, they are oases. The same could be said to a lesser extent of European and Japanese stocks. Understandably, Americans have preferred to find their dividends at home, where things look a lot less scary. But you'll never find the best values while nestled in the false comfort of conventional behavior. The other part of doing yield right is throwing fistfuls of cash at investments that offer a lot of value. And this usually means doing scary, unconventional things.
A version of this article originally appeared in the September 2012 issue of ETF Investor.
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