A Portfolio for IRA Investors: Identifying Opportunities in Current Volatility

Includes: FOF, NLY, NTG, PKO, T, UTG, XLU
by: Steven Bavaria

Despite there being about $5 trillion invested in IRAs, there are surprisingly no mutual funds-- or other investment vehicles that I have run across in 30 years of investing-- that are designed specifically for IRA investors. As a result, many IRA investors do not realize that volatile periods like the current one actually offer them unique opportunities, as long as we maintain our long-term goals and don’t lose our nerve when much of the market appears to be panicking.

Because IRA investors are able to trade in and out of positions without tax consequences, it means we can shift portfolio holdings quickly in response to market movements. This is a valuable tactical advantage in dealing with fast-moving markets that investors in taxable accounts do not have, since they have to worry about capital gains taxes every time they adjust their portfolio.

This tax advantage allows IRA investors to rebalance their portfolios – dumping some investments, bulking up on others – in response to market movements without worrying about capital gains and losses. In tweaking my portfolio, especially during volatile market periods, I always try to focus on the goal of increasing the net income stream, irrespective of what value the market may put on the portfolio at any given moment.

Note that I am NOT referring to or recommending market timing per se (i.e. trying to judge overall market highs and lows), in that I seldom depart from a fully invested position in my own account. As an investor who largely lives on the dividends and interest from his own portfolio (i.e. I have to “eat my own cooking” in terms of my investment decisions), I fear being out of the market and missing out on both the income and the capital gains even more than I fear having the value of my investments decline.

Therefore I use market disruptions as an opportunity to sell out of holdings that I like that have NOT gone down relatively as much, and use the proceeds to buy others that have gone down relatively more. In so doing I can increase the absolute income stream and overall yield on the whole portfolio. The overall portfolio may be worth less than it was the previous day, but by selling out the holdings that held up better and buying into the ones that dropped more, I can increase my current income stream. Nothing takes the sting out of seeing your holdings worth less after a down day or two than knowing you are actually earning more income from the portfolio than you were a day or so earlier, when it was worth more in market terms.

IRA investors, in particular, are in a good position to adopt that sort of attitude and strategy to their personal portfolio management.

Individual retirement accounts (IRAs) – the grand strategy

The goal of most IRA investors is to accumulate assets over a long period of time, with a view to drawing them down after retirement as either a main source of income or to supplement pensions and other savings. The main advantage of IRAs (both regular and ROTH) is that the investments accumulate tax-free until they are withdrawn (and in the case of ROTH IRAs, they are withdrawn tax-free as well). This means that investors can (1) make investment decisions with virtually no regard to the tax consequences of the individual buy / sell decision, and (2) can buy securities that may be attractive income generators but which would not be efficient holdings in a taxable portfolio.

As mentioned above, as a $5 trillion investment category, you would think there would be a whole slew of mutual funds and other investment vehicles marketed specifically to the IRA investor. But in the almost 30 years since I started managing my first IRA (the rollover in 1986 of the 401K from my first job) I have yet to see a single fund or other vehicle designed for IRAs. Therefore, I have essentially created my own “IRA mutual fund” within my own portfolio. In doing so, here are the main principles I follow:

  • To be eligible for consideration, an investment must pay minimum interest or dividend of 4% (the minimum may rise as interest rates go up in future); this recognizes that the ability to compound tax-free within an IRA is a valuable feature which is wasted if an asset generates no cash income; if you’re going to look solely to the capital gain for your upside reward, why bother to hold the asset in an IRA and waste the ability to shelter current income?)
  • I seek both growth and income investments.
  • “Growth investments” are companies that meet my current dividend hurdle (4%) but offer dividend growth prospects of another 4-5% or higher, so that the long-term growth is at least in the high single digits.
  • “Income investments” are securities where the current income is high enough (and secure enough) that I am happy to hold it in my portfolio even if it hardly ever or never grows. Junk bonds, floating rate loans, mortgage REITs, fixed income closed end funds, etc. with yields of 7-8% and higher are examples of this category.

Managing the Portfolio

The goal of all this is to assemble a portfolio where every asset – come hell or high water – pays minimal dividend or interest income, with a healthy slug of the portfolio made up of “dividend growers” so the total income stream will be steadily increasing.

I monitor the income stream religiously, with a continuously updated Excel spread sheet that lists all holdings, the number of shares of each, the dividend / coupon rate per share and the number of times per year it is paid (monthly or quarterly). This allows me to calculate the monthly and annual income from the entire portfolio, updated each time I change holdings or the dividend rate is raised (or lowered) on individual holdings. I also track the balance between what I call “fixed income” and “growth income”, the former being high-yields with little potential growth and the latter being both high dividends and reasonable future growth prospects. Currently my portfolio is almost evenly split between fixed income and growth income securities, with the average current yield on the entire portfolio about 6.2%.

Largest “Fixed Income” Holdings, as of 8/15/2011:

  • Annaly Mortgage (NYSE:NLY) – mortgage REIT
  • Third Avenue Focused Fund (TFCIX / TFCVX) – opportunistic credit fund
  • Vanguard High Yield Corporate Fund (VWEAX) – high yield bond fund
  • PIMCO Income Opportunity Fund (NYSE:PKO) – closed end income fund

Largest “Growth Income” Holdings, as of 8/15/2011:

  • Cohen & Steers Closed-End Opportunity Fund (NYSE:FOF) – closed end “fund of funds”
  • Reaves Utility Income Fund (NYSEMKT:UTG) – closed end utility and telecom fund (particularly valuable holding for IRAs because it holds such a great combination of high-yielding firms, including some with solid growth prospects and other long-term "steady eddie" high dividend payers)
  • Sector SPDR Utilities (NYSEARCA:XLU) – utilities ETF
  • Tortoise MLP Fund (NYSE:NTG) – closed end MLP fund
  • AT&T (NYSE:T)

As suggested earlier, my goal over time is to grow the income stream that this portfolio generates, since that is what I will have to live on some day when I am fully retired. The more you focus on that income stream – what it currently is, whether you have investments that will consistently maintain it and allow it to grow – the easier it is NOT to fixate on market fluctuations and how much the portfolio is valued by the market from one day, week or month to the next. In fact, if you put this strategy into practice and your portfolio is churning out a steady 5-6% per year that has to be re-invested (and is growing that stream modestly each year as well), you actually begin to appreciate market downturns because they allow you to re-invest your current income at a higher yield.

Disclosure: I am long T, NTG, XLU, UTG, FOF, NLY, PKO.

Additional disclosure: I also own VWEAX (Vanguard High Yield Corporate Fund), and TFCIX (Third Avenue Focused Credit Fund) which are mutual funds.