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In a recent post, I talked about how some income-seeking investors are using the strategy of investing in multiple asset classes in order to find yield. As an example, I referred to the iShares Multi-Asset Income ETF (IYLD), which seeks to deliver yield and balance risk through diversified asset allocation.

In order to reach its goals, IYLD invests in some lower-yielding asset classes that may seem a little out of place for a fund that has the word “income” in the title. For example, it has about a 15% allocation to the iShares 20+ Year Treasury Bond ETF (TLT) - currently yielding a rather unimpressive 2.8% [1]. Which begs the question: Why would a yield-oriented ETF invest in asset classes that aren’t yielding very much? The answer, in a word, is diversification. TLT’s role in the portfolio is not to add income but rather to help decrease risk and to assist in providing relative stability to the fund’s performance.

Take a look at the chart below, which shows the hypothetical 5-year growth of $100 invested three different ways: the iShares 20+ Year Treasury Bond ETF (TLT), the iShares Select Dividend ETF (DVY - another one of IYLD’s holdings), and a hypothetical portfolio consisting of 50% in each (rebalanced monthly).

(click to enlarge)

So what does this tell us? First, you can see that TLT and DVY tend to move inversely, which is a good sign in terms of diversification. When the assets in a portfolio don’t move in synch, the volatility of the portfolio is reduced. This is why a diversified portfolio usually experiences less risk than the weighted average risk of its constituents - and often less risk than its least risky constituent. Let’s see if that’s the case with this example:

DVY TLT 50/50 Portfolio
Return 4.00% 7.71% 7.63%
Standard Dev 18.58% 16.79% 11.48%
Sharpe Ratio 0.19 0.43 0.62

As you can see, the 50/50 portfolio returned almost as much as TLT did, but with less risk in the form of a lower standard deviation and a higher Sharpe ratio (the greater a portfolio’s Sharpe Ratio, the higher its risk-adjusted returns have been). Note that the 50/50 portfolio return is hypothetical and does not reflect an actual portfolio or investment. (Returns do not reflect any management fees, transaction costs or expenses. Past performance does not guarantee future results.)

If managing risk is one of your investment goals, as it is for IYLD, then diversification is a practice you’ll want to get acquainted with.

[1] Distribution yield as of 6/20/2013. The distribution yield represents the annual yield an investor would receive if the most recent fund distribution stayed the same going forward. The yield represents a single distribution from the fund and does not represent the total return of the fund. The yield is calculated by annualizing the most recent distribution and dividing by the fund NAV from the as-of date. This information must be accompanied by a current prospectus, which can be obtained by clicking HERE.

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Source: Want Lower Risk? Try To Diversify