An Investment Strategy Balancing Growth And Income (Part 1)

by: Efficient Alpha

By Joseph Hogue, CFA

The daily onslaught of articles on individual stocks and equity market developments often masks the fact that most investors are better served with a good long-term strategy. The stock market, as well as investments in other asset classes, will fluctuate from day-to-day but of more importance is the long-term trend and return to the investor's nest egg. A long-term strategy should include diversification in asset types and economic drivers while providing for growth and income suitable to the investor's time horizon and risk tolerance.

While individual investors need to assess their own needs in terms of risk and return requirements, there is some overlap in portfolio construction. The investments and percentage allocations below will not be suitable for all investors but can be used as a start to constructing your own portfolio.

The portfolio described below should be a portion of your total investable assets, not the entire nest egg. While some of the components may satisfy the need for different asset classes, i.e. real estate and alternative assets, you will still need an allocation in bonds. Investment in emerging market bonds are described as part of the EM portion in part two of the article, but these fund investments behave similarly to stock investments and do not satisfy the need for fixed income investments in your portfolio. Investors should always incorporate some form of cash holdings, whether through treasuries or money-market funds, to satisfy short-term needs.

U.S. Sector Core (35%)

While it may not return the income or growth of the other assets in the portfolio, a core holding in U.S. S&P500 companies will provide a broad base of diversification and stability to your holdings. Despite structural problems in the economy and an ever increasing debt problem, American companies have proven their ability to adapt and seek out growth.

Two options are available when developing the core portion of the portfolio. Investors could simply buy shares of the broad market through a fund like the S&P SPDR (NYSEARCA:SPY) which tracks the S&P500 or could choose from the sector funds to track individual sectors. As more sectors are added, the aggregate portfolio begins to mimic the broader index so there may be little difference between the two options.

The Technology Select SPDR (NYSEARCA:XLK) holds the shares of 80 companies within the various tech-related industries. The fund pays a dividend yield of 1.4% and charges an expense ratio of 0.18%. Investment in capital and technology has been strong over the last year and should continue as companies look to put cash to work for higher productivity.

The Financial Select SPDR (NYSEARCA:XLF) holds the shares of 83 companies within the financial services industry. The fund pays a yield of 1.5% and charges an expense ratio of 0.18%. Though the financials have underperformed since the end of the recession, valuations are fairly attractive and the industry should bounce back over the long-term.

The Consumer Staples Select SPDR (NYSEARCA:XLP) holds the shares of 42 non-cyclical companies. The fund pays a relatively high dividend yield of 2.7% and charges an expense ratio of 0.18%. While growth potential in the consumer staples is lower than the other two sectors, the fund provides stable income with protection of cyclical diversity.

You may not need to add exposure to energy or basic materials as these will be gained through other portions of the portfolio, i.e. materials exposure through emerging markets and energy exposure through Master Limited Partnerships.

Energy & Master Limited Partnerships (15%)

There is a structural change happening in the U.S. energy market. The boom in continental production through shale is bringing natural gas prices down to 10-year lows and increasing the amount of proven reserves in our own backyards. While activists will continue to lobby for alternative fuels, the demand for oil and natural gas products will remain strong for decades to come.

With a market cap of $216.7 billion, Chevron (NYSE:CVX) is by far the largest in the portfolio and provides the most diversification. The company engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. Operations include both upstream (exploration & development) and downstream (refining & marketing). The shares are up about 6.5% over the last year and pay a reasonable 3.0% dividend yield.

Master Limited Partnerships have been popular lately as a high-income play on the energy sector. MLPs are a special type of company under the tax code. Like REITs, they are exempt from corporate taxes as long as a certain percentage of income is returned to the general partner (management) and limited partners (investors). MLPs trade on the exchanges like stocks but typically pay much higher dividends, which are called distributions. For the pipeline operators, MLPs may also be a more stable play on the energy sector than traditional integrated firms because profitability is exposed to volumes rather than prices. Though prices for natural gas may be dropping precipitously, volume transported is more stable so business is less volatile.

Investors do need to understand the complicated tax structure for MLPs. Around 80% of distributions is taxed as a return of capital and payable on sale of the stock, but roughly 20% of distributions are taxed in the year received at the investor's marginal rate. Beyond this, there are some situations where distributions in a tax-deferred account may be subject to taxes so investors should look further into details relating to their particular situation.

Linn Energy (LINE) acquires and develops oil & gas properties across the United States. Shares are basically flat over the past 12 months but pay a distribution of 7.4%, the highest of the group. Bloomberg reported last week that Linn agreed to pay $1.2 billion for BP's natural gas holdings in Kansas, increasing proved reserves by 730 billion cubic feet. The company has entered into hedging contracts for 100% of natural gas production and 68% of NGL production for five years giving the company plenty of time for natural gas demand to increase to meet supply. The company has completed a little over $4 billion in acquisitions over the past two years making it an extremely strong player when prices do rebound.

Enterprise Products Partners (NYSE:EPD) provides midstream energy services to producers and consumers of natural gas, natural gas liquids, refined and crude petroleum and petrochemicals. The company operates approximately 50,200 miles of onshore and offshore pipelines and 192 million barrels of storage capacity for NGLs. Shares pay a 4.8% distribution and enjoy the tax benefits of a master limited partnership.

Real Estate (10%)

Despite the weakness in residential real estate over the last few years, investment in commercial real estate is still a strong part of a diversified portfolio. The tax advantaged status of Real Estate Investment Trusts (REITS) give them a competitive advantage against other investments and allow for growth while still providing a high level of income. These investment vehicles offer a great opportunity for the individual investor to participate in stable income and growth in commercial real estate without large outlays of cash and intensive management.

As with any investment complicated by special tax rules, individual investors must understand how REITs fit with their own circumstances as well as understanding the risk that a change in the tax code could lead to a significant decline in share price.

The Vanguard REIT ETF (NYSEARCA:VNQ) invests in 111 publicly-traded REITs based in the United States. Specific types of REITs include: specialized (28.4%), retail (26.3%), residential (18.3%), office (16.1%), and industrial (4.9%). The fund pays a dividend yield of 3.3% and charges an expense ratio of 0.12%.

The Vanguard Global ex-US Real Estate ETF (NASDAQ:VNQI) helps to diversify real estate exposure globally with investment in 453 global real estate companies. The fund holds a large percentage in developed markets but also invests in emerging markets with sizable holdings in Singapore (7.5%), China (6.6%), South Africa (2.4%), and Brazil (2.2%). The fund charges an expense ratio of 0.35% and has paid out two distributions since December 2010. The last distribution of $1.33 is approximately 2.8% of the current price. A recent article, prompted by a Bloomberg interview with Sam Zell, surveyed the opportunities and investment vehicles in emerging market real estate.

The investments described here are obviously not the only way to put together a solid growth & income portfolio, nor are they probably the best. They do represent a rationale framework for diversification and tax-advantaged gains without the need to 'time' the market on a monthly or even yearly basis. Use of funds gives the investor the ability to diversify holdings over hundreds of companies and eliminate non-systematic risk. Beyond issues of portfolio construction, as described in this article, investors need to consider their own needs and tolerance to decide the appropriate level of portfolio protection.

Part two of the series will cover investments in emerging markets and hedge funds. While the investments in described above may offer lower growth but more stability, those investments described in part two will add higher growth and incremental risk to the portfolio.

Disclosure: I am long XLF, XLK, LINE.