Alternatives to Buy and Hold for Income Investors

In previous articles, I have detailed some sample portfolios that can be used in conjunction with a tactical asset allocation moving average strategy. For many readers who are nearing or in the early stages of retirement, however, the sample portfolios may not reflect their risk tolerance or desired allocation. This article lays out one example of a dividend focused ETF portfolio with a 40% allocation to bonds. There are numerous other considerations and alternatives in constructing a retirement portfolio (taxes, cash allocation, CD laddering, tax-free investments, age, etc.), but for those looking for a sample of a income generating investment portfolio, the chart below can serve as a starting point. Combined with a moving average strategy presented by professionals such as Mebane Faber, Tom Lydon, and others, an investor with a lower risk tolerance can use a more conservation asset allocation model to further increase risk-adjusted returns.

As if market participants needed a further reminder about the limits of relying exclusively on diversification for risk management, dshort.com summed up 2008 by reminding us that 'diversification works...until it doesn't'. Most retirees or near-retirees cannot afford to see a 40-50% reduction in the equity portion of their portfolio, which for many of these investors still accounts (or accounted) for 40-60% of their holdings. Due to the power of compounding, that 50% loss requires a 100% gain to make back lost money. Capital preservation is critical for investors who need to rely on their capital to generate a monthly paycheck. Given the choice between losing 40% in one year on an investment yielding 5% or allocating that money for a year to risk free cash yielding 1-2%, every investor would choose the latter.

What is a conservative, or any, investor to do? One option is to follow a tactical asset allocation model. If one had followed a simple tactical asset allocation model in 2008, the portion of one's portfolio slated for equities would have been transitioned to cash early in the year as the major indexes fell below most long term moving averages and thus precious capital would have been preserved. Yield is critical for retirees to generate income, but even more critical and that which one cannot lose sight in the search for income is the need to avoid substantial drawdowns in capital due to significant market fluctations. A tactical asset allocation model is designed to do just that – avoid the major declines of bear markets and catch the majority, albeit not the entirety, of a bull market.

A simple ETF portfolio with an income focus could look like following. If one was using the 200-day EMA to determine buy/sell signals and updating positions on a monthly basis, the positions highlighted in bold would be long positions. The allocations dedicated to the non-bold postions would be in cash. As you can see below, it would be a relatively boring portfolio today with only 4 long positions out of a possible 19. Then again, a portfolio constructed along a moving average strategy would have had a positive return for 2008.

For further research and links to other resources, please visit my previous articles here and here as well as those I have cited in my articles. Also, Mebane Faber has a new book available discussing this very strategy, I have not read it yet but I think it would be well worth your time to check it out.

*Claymore plans a momentum based commodities ETF according to IndexUniverse.com. As I've previously written, LSC (or RYMFX) was used as a suggestion for a portion of commodity allocation due to its low correlation to equity markets and commodity markets. The downfall with LSC, however, was that it was an ETN and thus there is an element of credit risk. For those worried about the credit risk of ETNs but were intrigued by LSC, the new Claymore ETF could serve as a viable alternative.

Disclosure: None.

Comments

[Rhunzzz:]

One thing I don't understand about using the EMA or SMA. When I look it up on Yahoo! Finance, what is the "range" I should choose? 1 day? 5 days? 1 month? Depending on which range I pick, the 200-day EMA or SMA function might be above or below the stock or ETF price chart.

Mar 31 07:55 AM

[Scott's Inv...:]

I would use the daily function when using moving average strategies -

Mar 31 08:50 AM

[Alan Young:]

I don't believe all the yield information in your table is up to date. For example, TIP hasn't paid any yield in about 6 months. Due diligence needed.

Mar 31 09:18 AM

[richjoy403:]

Scott--Thank you for a very useful article...I can't help but think it might be 'tweaked' a bit, thus a couple questions:
(1) Does the 100-day EMA work equally well in bull and bear markets (i.e.; if one feels we are now quite near a bottom, would a 65-day EMA be a reasonable rule?...(and conversely, when the market looks to be near a top, would a 65-day EMA be more likely to get one out and preserve profits?).
(2) Does your 100-day EMA work equally well for all asset classes (e.g.; stock, bond, commodity, and real estate ETFs, and individual stocks)?

Mar 31 09:23 AM

[User 377279:]

Call Ishares about the dividend. They do not have to pay every month or quarter but can hold dividend payments to end of year.


On Mar 31 09:18 AM Aalan wrote:

> I don't believe all the yield information in your table is up to
> date. For example, TIP hasn't paid any yield in about 6 months. Due
> diligence needed.

Mar 31 12:22 PM

[Lightway:]

Some of those commodity picks show 0 yield on them. I know they are in there for diversification, but what's the though behind including them in the portfolio if they are offering no income?

Mar 31 01:34 PM

[searcher:]

'diversification works...until it doesn't' Truly, the correlation in a panic approaches 1.0 for most equities. Another type of diversification, time (riding it out), is less an option for those who must deplete their principal even minimally. It's gut wrenching when the income from any equity melts away with a dividend cut.

Mar 31 02:36 PM

[Scott's Inv...:]

Regarding the yields, they were all pulled either directly from the ETF provider website or in some cases yahoo finance. Obviously investors need to be aware of changing yields given the volatility of the market/dividend cuts as well as ex-dividend dates and frequency.

User329713: Your first question really is the crux of the issue - trying to time the market. I would pick a long term average and stick with it (100day+). For some performance data regarding the 100 day sma, see Merriman on fundadvice.com.

However, given the depth of the decline, for many indices there certainly is a lot of upside between here and the 200 day ema. I would highly suggest checking out Tom Lydon's site for one way to deal with this. A similiar strategy to Lydon's would be to do the following (which entails added transactions costs/potential tax implications/whipsaws/and some added risk to consider): Take 50% of what you would normally allocate to a position. When that equity crosses a shorter term MA (like the 65 day ema you mentioned, or more commonly the 50 day), use that as buy signal on the 50% allocation. If the equity crosses below the average again, sell. To avoid whipsaws, you could set a 1-5% buffer (you decide the exact #) on the average so the position would actually have to rise/fall 1-5% above/below the moving average before a buy/sell signal. Then, when the equity crosses the longer term average like the 200 day, buy with the other 50% you have allocated for that position. This would help 'catch' some of the upside when it happens while still limiting some of your risk.

Mar 31 09:00 PM

[Scott's Inv...:]

Lightway: the commodities were included as diversifier - they often have very lower correlation to equity markets (in some case negative correlation). Obviously this portfolio took on a little more risk/desire for capital appreciation then a 90 year olds portfolio may take. I would suggest commodities to be at least at least a small portion of just about any portfolio, but obviously the total percentage could be adjusted based on risk tolerance/income needs.

Mar 31 09:04 PM

[Lightway:]

Thanks for the response.

I have an almost exact allocation of commodities in my personal portfolio as the allocation in your chart above, for the same reasons you had mentioned. The only thing I'm missing is the S&P momentum index product LSC, so I'm doing some diligence to see if that fits into my strategy. I've started tracking the ETF and am definitely interested in opening a position.

Thanks again for the article.


On Mar 31 09:04 PM Scott's Investments wrote:

> Lightway: the commodities were included as diversifier - they often
> have very lower correlation to equity markets (in some case negative
> correlation). Obviously this portfolio took on a little more risk/desire
> for capital appreciation then a 90 year olds portfolio may take.
> I would suggest commodities to be at least at least a small portion
> of just about any portfolio, but obviously the total percentage could
> be adjusted based on risk tolerance/income needs.

Apr 01 03:59 AM

[Lightway:]

TIP pays out according to the inflation rate, and since we've just gone through a period of low inflation/mild deflation, they won't pay a yield until inflation goes back up.

This is a mechanism of the underlying inflation-protected Treasury bonds that TIP buys, not really due to their own performance or income rules.

Personally, I think the TIP yield for 2010-2011 will be solid, as the economy recovers, money supply makes its way through the system, and credit markets go back to "normal." So for now, it's a good time to load up, and TIP does not fluctuate too much in it's share price.

On Mar 31 09:18 AM Aalan wrote:

> I don't believe all the yield information in your table is up to
> date. For example, TIP hasn't paid any yield in about 6 months.
> Due diligence needed.

Apr 01 04:07 AM

[Scott's Inv...:]

Many finance professionals include TIPS as an 'alternative' investment along the lines of commodities, gold, absolute return funds, etc., since they tend to have a lower correlation to the rest of the bond market. TIPS have performed well recently and I think are a critical element to anyone's portfolio, high or low risk, to hedge against inflation and collect a little yield along the way.

Apr 01 10:20 AM

[RiskReturnO...:]

I've created a simple "new asset class" using two ETF's (LQD and TBT). This will be the credit spread between corporate bonds and long term treasury. I'm long this pair when fear is high in the market, and covering the long position when things "go back to normal."

Anyone know of a better way to trade the above excess credit spread using liquid ETFs?

Apr 01 11:23 PM

[Lightway:]

Riskreturn,

Not quite what you had in mind, and it replaces corporate with munis, but there's a new ETF out for Prerefunded Bonds:

seekingalpha.com/artic...

Apr 03 03:30 AM

[User 332147:]

This might be a silly quesiton, but I do wonder about the mertis of doing timing strategies for TIP, LQD, or BND. Most of these maintain "relative" price stability and thus it seems to have an active strategy based on the price momentum is a waste of time. However I'm completely sold on using TAA for the equity, commodity and real estate side of your portfolio. What am I missing?

Apr 06 08:33 PM

[Scott's Inv...:]

It's a fair question - volatility in bond investments tends to be lower then in equities. However, I would read Faber's paper for some results - bonds (10 yr govt) using a timing model had an annualized return of 9.11% vs 8.75% on buy and hold from 1973-2008. The key is that the volatility was 7.6% vs 9.05% on a buy and hold. He doesn't have corporate bond results, but I would suspect lower volatility there as well.

Apr 07 12:38 AM

[BGRT:]

History's shown that commodity price spikes don't last for long. A 10% allocation just to commodities is 10% of your money not being used to earn income. Instead of ETFs like DBC, why not Canadian energy trusts (I believe there is an ETF that tracks these trusts), Int'l basic materials and energy sector ETFs which will all increase in value when commodity prices rise but will at least give some income in case commodities stay flat for a decade. The WisdomTree int'l sector ETFs yield something like 5-7% currently.

May 30 07:10 AM