Retirement Portfolio Strategy: Diversification, High Yields, And Low Risk With 9 ETFs

by: Glyndon Park

Summary

Retiree portfolios emphasize income with a focus on reduced risk and diversification.

Recommend a mix of asset class and geographic diversification.

Recommend 9 ETFs for a high income low risk diversified retiree portfolio.

We recently constructed a model retirement portfolio seeking to maximize current income while maintaining prudent diversification to various asset classes and geographic exposures.

The first step was to determine our asset and geographic diversification. From an asset class perspective, the model is heavily weighted towards fixed income with 55% allocated.

Recognizing that yield is historically low, there is no allocation to treasuries or cash as the risk/reward is just not viable for retirement investor seeking to preserve purchasing power. At nearly every point on the yield curve the after-tax return is lower than inflation. Secondly, we removed municipal bonds, again yields were low until further out on the curve. Assuming more risk and a dependency on the tax brackets may or may not be optimal for any investor. We recommend investors evaluate municipals in the context of their own portfolios, state tax rules, and income and if circumstances dictate allocate a portion of the credit/preferred bucket to municipals.

We recommend the credit/preferred bucket be allocated entirely to domestic instruments. In the current environment, with domestic yields low, any rise in rates would likely result in a stronger dollar, adding potential total return downside to foreign holdings with a fixed return. We leave international exposure to equities and real estate with more upside potential.

We recommend a 30% allocation to equities, with 20% domestic and 10% international. The equity allocation is necessary to preserve a retiree's purchasing power over the long term. Ensuring an adequate international exposure can smooth the impact of economic cycles over time.

Finally we recommend a 15% allocation to real estate related assets. Both domestic and international real estate offer significant diversification to the portfolio and are income investments with moderate growth over time.

Asset Class

Domestic

International

Total

Equity

20.00%

10.00%

30.00%

Real Estate

10.00%

5.00%

15.00%

Credit/Preferred

55.00%

0.00%

55.00%

85.00%

15.00%

100.00%

Click to enlarge

Next we recommend specific ETF investments to achieve the above allocations. In each case, we look at the yield and standard deviation, which is utilized to estimate potential downside or losses that could occur. We've estimated the losses for each investment in terms of worst in 100 years, 20 years and the average loss in a down year.

Asset Class

Allocation

Symbol

Yield

Allocation

Weighted Avg Yield

Standard Dev

Estimated Worst Year in 100

Worst Year in 20

Average Down Year

Equity

Domestic Equity

DVY

3.04%

20.00%

0.61%

9.8%

$4,554.31

$3,220.91

$1,958.00

Equity

International

IDV

4.76%

10.00%

0.48%

17.9%

$4,156.56

$2,939.62

$1,787.00

Real Estate

Domestic

IYR

3.79%

5.00%

0.19%

15.8%

$1,838.70

$1,300.37

$790.50

Real Estate

Mortgage REIT

REM

15.75%

5.00%

0.79%

14.9%

$1,736.36

$1,227.99

$746.50

Real Estate

International

WPS

4.31%

5.00%

0.22%

17.8%

$2,064.33

$1,459.94

$887.50

Credit

Domestic

LQD

3.69%

20.00%

0.74%

5.7%

$2,637.68

$1,865.43

$1,134.00

Credit

Domestic

CLY

4.74%

5.00%

0.24%

8.6%

$995.53

$704.06

$428.00

Credit

Domestic

HYG

5.90%

15.00%

0.89%

7.4%

$2,592.33

$1,833.35

$1,114.50

Preferred Stock

Domestic

PFF

6.56%

15.00%

0.98%

7.4%

$2,574.88

$1,821.02

$1,107.00

100.0%

5.12%

9.95%

$23,150.68

$16,372.69

$9,953.00

VIX

$33,444.35

$25,316.20

$14,980.00

Click to enlarge

For the domestic equity investment we recommend a 20% allocation to the Select Dividend ETF (NYSEARCA:DVY). Over the last 12 months, the fund has paid a dividend yield of 3.04% and standard deviation of 9.8% and is concentrated in large capitalization stocks that provide stability to the portfolio. The standard deviation of 9.8% is very modest relative to most domestic stock indexes.

For international equity, we recommend a 10% allocation to the International Select Dividend (NYSEARCA:IDV). Over the past 12 months, the fund has yielded 4.76% with a standard deviation of 17.9%. The fund invests in quality international higher dividend stocks providing substantial current income albeit with a higher standard deviation. Typically, international funds have lower correlation that can reduce the overall portfolio volatility. With this in mind and the high yield, this fund is an optimal portfolio ETF for retirees.

For domestic real estate we split the 10% allocation between two types of REIT ETFs. The first is the US Real Estate ETF (NYSEARCA:IYR) with a yield of 3.79% over the last twelve months. The fund invests in large capitalization domestic REITs across an array of investment types.

Second is the Mortgage REIT ETF (NYSEARCA:REM) with a yield of 15.75% over the last twelve months and 14.9% standard deviation. These investments use substantial leverage to boost dividends ideal for an income-seeking investor. The high yields are not without risk -- REITs can struggle in periods of rising rates and outperform in downward rate environments. Most often the rate sensitivity cushions the equity allocation that tends to move up and down with economic cycles.

For the international REIT exposure we recommend a 5% allocation to International Developed Property ETF (NYSEARCA:WPS). The fund invests in non-US REITs boasting a yield of 4.31% over the last twelve months. The fund is invested across numerous regions offering retirees a well-diversified exposure to the global income producing real estate market.

For the domestic credit allocation we recommend a 20% allocation to the investment grade bond ETF (NYSEARCA:LQD) with a 3.69% and very modest standard deviation of 5.7%. The fund holds a well-diversified portfolio of investment grade corporate bonds. The relative safety of these investments commands a substantial allocation for an income seeking retiree. To supplement the yield we recommend a 5% allocation to the similar, 10 Year+ Credit bond (NYSEARCA:CLY) fund. This fund yielded 4.74% over the last twelve months with a similar credit profile but higher standard deviation than LQD. The additional yield and longer maturity provides additional income to retirees and a modest hedge should rates not rise rapidly.

We recommend a 15% allocation to the High Yield Bond ETF (NYSEARCA:HYG). In a well-diversified portfolio high yields is a crucial holding for retirees seeking income. The 5.9% yield provides substantial income albeit with greater credit risk. Given high yields correlation to other asset classes, the substantial yield pick-up is well worth the marginal portfolio risk when diversification is factored.

Finally we recommend a 15% allocation to the US Preferred Stock ETF (NYSEARCA:PFF). Much like high yield preferred stocks are crucial to an income seeking retiree. PFF yields 6.56% and in a diversified portfolio may only marginally increase risk. In many cases preferred dividends are tax advantaged at the lower dividend versus ordinary income tax rates.

Overall the recommended 9 ETF portfolio yields 5.12% offering a well diversified exposure to numerous asset classes and geographic regions.

The yield is only half the investors' consideration. Using the reported standard deviation we've estimated the worst projected loss over three time periods assuming a $100,000 portfolio. This metric allows investors to gauge the return relative to potential downside.

We've summed those values for the overall portfolio in each time period. This figure represents the absolute worst of the worst case scenarios as it is unlikely that every ETF would have its worst year at the same time. The figure is useful in comparison to the values calculated on the last line which represent the worst case for the S&P500 based on the ^VIX index. Retiree investors should note the 9 ETF portfolios offers a much higher yield, above 5% versus below 2% for the S&P500. At the same time the worst-case scenario is lower than that implied by the VIX index. Meaning for income the 9 ETF portfolio offers better risk/reward than an equity index fund.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.