Many investors, individuals and charitable organizations are looking to their investments to provide additional income at a time when interest rates are being artificially depressed. Here is a real-life case study of how the objectives of an income-needing group were currently approached using ETFs.
The Board of a not-for-profit organization has the Mission to "Promote, Program, and Preserve" a unique San Diego civic asset, the largest outdoor pipe organ in the Western World. It was built in 1914 and donated to the city "to benefit the citizens of San Diego and of all the World" by John and Adolf Spreckels, heirs of the Spreckels Sugar fortune.
The organ's deed of gift prohibits any charge to hear performances on the instrument. The Spreckels Organ Society lives on public donations, and has built an endowment fund from bequests of generous former audience and Society Members. Half a dozen Trustees form the Endowment Committee, which self-directs the investments. They include investment professionals, active individual investors, experienced business leaders, and past and current Presidents of the SOS.
Like most such organizations, tight financial times have reduced donation flows, making income from the endowment fund an important matter. The Endowment Committee just reviewed what income-generating alternatives are being offered by ETFs, in comparison with other existing sources. The risk vs. reward tradeoff is prominent in its considerations, given the overall investment environment and the impact of U.S. Federal policies on interest rates in general.
Existing SOS bond holdings yielding upwards of 6-8% on cost are intended to be held to maturity, so no principal loss on them due to interest rates rising from present artificially depressed levels is a concern. But that consideration, coupled with the trivial yields present, urges the strategic decision to not make any current further bond investments, or buys of ETFs tracking bond portfolios or indexes.
Several equity-based ETFs have been designed to provide dividend-driven income flows to their investors. The more widely-held and actively-traded are included in this price-based Reward~Risk Tradeoff picture:
Reward : Risk Tradeoffs for Income-Driven ETFs
The following table provides data on current yields offered, and prior price experiences subsequent to forecasts like those pictured above.
Of principal tactical interest in this table are the Current Yield column and the next-to-last column titled "sample size." The latter column refers to the extent of available forecast history in each issue, in market days, and recognizes the potential trap of attractions arising from insufficient data..
The SOS Endowment Committee's concerns reach back in time to the prior market peak in September 2007, some 1350+ market days ago. Earlier histories were set aside. ETFs with lesser histories were at a persuasion disability, and ones with less than two 252-day years were, for this selection, fatally flawed.
While current yield was of principal interest, 1) how it comes about, 2) what might disrupt it, 3) how an unscheduled forced liquidation might diminish or offset it, and 4) what interim price-drop discomforts might be encountered, were all factors taken into consideration by this very conservative group.
Addressing concern #1) are the table's five bold-faced sub-headings. The set of high-dividend U.S. stock ETFs offers a typically broad-based, diversified source of companies with histories of continuing dividend payments. Particularly compelling to the committee was the SPDR S&P500 Dividends ETF (SDY) policy of investing in only 60 Stocks from the S&P500 index having long histories of dividends that increased year after year.
The somewhat higher yields of international dividend-paying stock ETFs reflects the market's appraisal of concern #2), a higher uncertainty of payment risk, perhaps largely due to general lack of familiarity with company specifics, and partly due to international politics, particularly in Europe, but not exclusively there.
Real estate ETFs provide some specific advantages in that their dividend sources are principally from rental income, both commercial and residential. REIT designations allow further special payout incentives. Current probability of recovery, both in economic activity and in residential property values, offers additional reassurance of yield improvement potential. The Vanguard REIT Index ETF (VNQ) has attracted the bulk of such investments.
Master Limited Partnership ETFs [MLPs], like REITs, have some related tax-motivated incentives to provide continuing payout assurances. Strengthening those legal advantages are technology developments in the energy-source-recovery industry. There, greatly expanding domestic economic recovery of oil and natural gas assure volume growth requiring expansion of delivery and processing systems. Industry practice has been to organize these in MLPs, and shifts in consumer energy usage and sourcing are likely to heighten the practice.
Preferred Stock ETFs offer the largest current yields, but typically, their holdings are near-totally in securities issued by financial industry organizations. The yields reflect a market discount of concern over any of a number of possible disadvantageous or disruptive potentials, the #2) concern again. This is another example of the market acting as a discounting mechanism, balancing returns against risks.
The #3) concern above, of unintended forced liquidation, is the reason for much of the table's data, including all of the columns between Current Yield and Sample Size. If the principal of endowment assets must, in a crisis, be utilized to assure the continued Mission of the organization, current decisions should seek to minimize the potential costs at that point.
Specifics of the current implied possible price change forecast pictured in the Risk~Reward Tradeoff visual are quantified in the table in the five columns to the right of the second numeric column, Assets under Management. Following them, the Range Index column measures what percent of the forecast range between Low and High prospects lies beneath the Current Price. Smaller RIs indicate larger upside prospects.
The next four columns relate what has happened in the past, when investments were made in all prior instances of a Range Index no less attractive than the present. Such hypothetical investments were limited to holding periods of six months, unless its price first reached or exceeded the High Forecast Sell Target.
The probability of a profitable outcome (as a % of the qualifying commitments) is a qualitative measure reassuring the likelihood of the Current Yield not being undermined by a #3) event. Please note that all of the prospective candidates scored profitable experiences in some 3 out of 4 (6 out of 8) hypothetical instances.
While the short-term outcomes associated with that probability may be of comparative interest to traders, the Endowment Committee's interest is solely with the quality vulnerability dimensions of the yield. The inclusion of all such experiences through time to the present reduces the emphasis on strictly current-day circumstances, while still offering some contemporary comparative guidance between alternatives.
Another of the tactical preference dimensions has to do with the interim discomforts that might be encountered in the event of market weaknesses, concern #4). The most right-hand column shows what typical worst-case (usually temporary) experiences were had during each of those 6-month holdings.
Every investment selection decision will be influenced by the individuals involved, and differing notions, experiences, and concerns are bound to dictate the outcome. This is what makes a market. If one has a number of underperforming mutual funds that could be liquidated, appropriate conservative choices of sources of ETF investment funds are available from these candidates, which could at least double incomes previously received.
The Spreckels Organ is played every Sunday at 2 pm, and Monday nights throughout each summer. It draws performers and visitors to the city from all U.S. states and from nations around the world, enriches the musical education of local schoolchildren, and encourages the interests and skills of aspiring young organists by providing scholarship awards.
Its 100th birthday will be celebrated on New Year 's Day of 2015, and with the rest of Balboa Park, its location, throughout the year. Many visitors to the city from abroad make attendance at a performance on the organ a pivotal part of their trip plans, and you could, too. Further details are always available on the website SOSorgan.com.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.