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In the first part of this article, I laid out my diversified, high-yielding portfolio comprised of stocks, preferred stocks, ETFs, and closed-end funds here. In this article, I'd like to expand on one of the opening statements of Part I -- that the portfolio is constructed to provide nice risk-adjusted returns, with "risk-adjusted" being the operative word.

Portfolio Comments

I received a number of beneficial comments on specific holdings of the portfolio. Tom in Texas wrote, "[Cheniere Energy] CQP plans to export LGN by expanding their facility in the next several years, but in the meantime, I can only see declining revenues."

I have done some additional due diligence on CQP, and after reading other discussions on this stock, coupled with the latest earnings report, I decided to sell my CQP position and replace it with another MLP, Enterprises Products Partners (EPD). EPD just increased its dividend, and its 10-year annual dividend growth rate is 8.3%. Additional motivation for owning EPD can be found here. My sale of CQP resulted in a small capital gain net of commissions. In this case, I am sacrificing a higher current yield for a lower, more sustainable yield with significant dividend growth upside. Replacing CQP with EPD lowered my portfolio yield on cost from 8.3% to 8.2%.

Tom McPartland wrote about Helios High Income Fund (HIH) and Helios Advantage Income Fund (HAV):

Wow -- I would have to check those Helios funds closely -- when I look at a five-year chart, chare [sic] prices are off by 90% -- yikes. Unfortunately the share price slides -- over time are much to frequent for these (and most) high yield CEFs. I would stick to building your own high yield portfolio.

My response to this is, before early 2009, HIH/HAV's stock chart is meaningless. The fund control was transferred and its new managers swapped out of various mortgage backed securities with a diversified set of high-yielding corporate bonds across various sectors.

Future questions and comments will be answered on the same page as the article.

Portfolio Volatility

Beta will be utilized to quantify this portfolio's volatility. Beta is a measure of a stock's volatility in relation to the market (henceforth, "market" will refer to the S&P 500). By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.

Given my desire to create "nice risk-adjusted returns," the remainder of this section will focus on the lower volatility of this portfolio relative to the market (as previously noted, the S&P 500). The yield of this portfolio (8.2%) provides returns close to the historical S&P 500 returns (~10% annualized) excluding unrealized capital gains. Any stock price appreciation is gravy.

Beta for an individual holding is calculated by: beta=covar(holding,S&P500)/var(S&P00), where covar is the covariance between the holding of choice and the S&P 500 and var is the variance of the S&P 500. In Excel, the formula would look like: =covar(holding array,S&P 500 array)/var(S&P 500) array.

To calculate beta, I first obtained historical stock price data (courtesy of Yahoo) with a temporal extent from April 2011 to January 2008. While the timeframe is somewhat arbitrary, it encompasses price movement before and after the financial meltdown. Monthly stock price data were used in the calculations, and monthly returns were calculated by taking the closing price difference in consecutive months (new minus old) and dividing by the older month closing price.

The table below summarizes each holding's beta relative to the S&P 500.

holding weight (%) beta weight*beta
OTCPK:AESAY 3.51 0.10 0.0036
ARR 4.61 0.14 0.0064
CHK.PD 7.67 0.10 0.0078
EPD 8.22 0.58 0.0477
DX 9.16 0.37 0.0338
GLAD 3.86 1.42 0.0548
HAV 4.22 0.40 0.0169
HIH 8.07 0.41 0.0327
HLMPR 3.81 1.41 0.0536
VKL 4.04 0.22 0.0090
LEG 3.93 1.31 0.0514
QQQX 4.08 1.08 0.0440
NHC+A 7.84 0.04 0.0032
CFD 7.22 0.86 0.0619
OTCQX:PMGYF 4.10 1.00 0.0411
RCS 3.85 0.34 0.0131
PSEC 7.98 0.79 0.0630
OTC:SOREF 3.85 -0.11 -0.0043
Total 100.00 n/a 0.54

To compute the portfolio's beta, simply multiply the holding's weight by the holding's beta, and sum. This gives a portfolio beta of 0.54.

Conclusion

This exercise demonstrates that this high-yielding portfolio is supposedly less risky than its S&P 500 benchmark (given the portfolio beta of 0.54). The current yield on cost (YOC) of 8.2% provides a return comparable to, but slightly less than, historical returns from the S&P 500. This portfolio should outperform the S&P 500 in both bear market and neutral market conditions. In Part 3 of this series, I'll investigate how long one has to wait to achieve a YOC of 10% given dividend reinvestment and changes in future holding distributions.

Source: My Diversified, High-Yield Portfolio - Part 2