In a future of lower expected price appreciation, investors should focus on the second leg of returns: income. ETFs make it incredibly easy to capture diversified sources of higher-yielding assets.
One of my favorite photos captures a line of over 8,000 people standing outside the Federal Reserve Bank of New York in August 1974 waiting to buy U.S. Treasury securities. With interest rates of 8.5% to 9.0%, investors craved these "high income" investments.
Source: Federal Reserve Bank of New York
The photo seems surreal today. For one thing, no one lines up to buy securities anymore. We're in a digital world where you can invest at home in your pajamas on a tablet. And 8% to 9% yields for perceived "risk-free" U.S. government securities? Well, that's as distant as the 45-cent price tag for a dozen eggs in 1974. Today's Treasury yields at comparable maturities are between roughly 2.5% and 3.0%.
But the strategy of finding and holding higher income-generating investments for the long term has held up well. I'd argue it's more relevant than ever. If you subscribe to a view that the expected returns for equity markets will be lower over the next five to ten years than the last five to ten years, then finding investments that have more yield potential than expected returns may help grow portfolio values.
3 ways to partake in the potential of compounding
Let's step back for a second. Portfolio performance - net after-tax total returns - can essentially be reduced to three components:
- Capital appreciation, the change in the market value of an asset
- Income, which usually comes in the form of dividends and interest payments
- Applicable taxes
When we talk about markets, we are typically talking about item 1, market price performance or capital appreciation. I find investors don't focus enough on item 2, income-generation - particularly in a long-term portfolio. For an investor who can stomach some market price volatility, the potential to clip a steady annual income return can have extraordinary compounding effects. As part of a long-term growth portfolio, consider carving out a portion for high-income strategies. It might be worth suffering some price drawdowns while reinvesting any income received in the same income-producing investments. As Albert Einstein famously said: "Compound interest is the eighth wonder of the world."
Investors have more options than ever when it comes to high-income strategies and the ability to compound savings over time. The ETF market, in particular, has opened up a broad menu of income-generating assets that go beyond the traditional corporate bond sectors. Outside an ETF, these assets would otherwise be extremely cumbersome or impossible for investors to access.
- Preferred stocks combine characteristics of bonds and stocks: they both pay a fixed dividend and offer the growth potential of shares. The iShares U.S. Preferred Stock ETF (NYSEARCA:PFF) provided a 30-day SEC yield of 5.4% as of July 31, and the lion's share of its dividend distributions constitute lower-tax-rate qualified dividend income (QDI) - making it tax efficient.
- Real estate sectors such as real estate investment trusts (REITs) are required to pass virtually all of their income on to investors, potentially resulting in attractive yields. The iShares Mortgage Real Estate ETF (BATS:REM), which invests in REITs and real estate stocks, had a 9.6% 30-day SEC yield as of July 31. It also serves as a diversifier in a traditional stock/bond portfolio.
- High yield bonds, as the name implies, likewise seek to generate higher income. The iShares Broad USD High Yield Corporate Bond ETF (BATS:USHY) provides exposure to the broadest possible universe of domestic high yield bonds with an expense ratio at just 22 basis points (.22%). It had a 6.2% 30-day SEC yield as of July 31.
How you invest depends on your own risk tolerance, but one might want to consider including these exposures in a portfolio.
Keep in mind, you will likely confront some bouts of volatility - these aren't risk-free assets from 1974. You may get some drawdowns in the value of these higher-income seeking strategies. I generally steer clear of things that perform exceptionally well unless I have a strong conviction about consistency of the income stream and a view on potential volatility.
There is wisdom in crowds. The line of 8,000 people at the door of the NY Fed understood that income-seeking strategies can be accretive to a long-term portfolio.
This post originally appeared on the BlackRock Blog.