Mutating The Hybrid Dividend Income Portfolio: Stocks Out, CEFs In

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Includes: AMZA, ARCC, BGAVF, CCCCF, CEFS, CETHF, CIK, CWVWF, DOLLF, ECC, EDIT, ELYGF, FDEU, GBTC, GPACF, HTGC, IAE, IGR, IHD, MORL, NHVCF, STK, STWD, TCPC, THQ, USTDD, UTF, UTG
by: Fast Track to Financial Independence
Summary

The portfolio is "hybrid" because in addition to income-focused positions, I also maintain some valuation plays.

Most individual stock risk in the income segment has been diversified away by a shift to closed-end funds (CEFs) or exchange-traded funds (ETFs).

The valuation play segment has been strengthened with several new mining stocks and a very small allocation to cryptocurrencies and biotech.

The result is a higher yield and higher risk portfolio that remains well diversified and backed up with a cash reserve.

Back in 2015, I presented my Hybrid Dividend Income Portfolio. It is "hybrid" because although most positions are income-focused, I also maintain some valuation plays that I believe might generate additional capital to feed new income segment purchases. At the time, I was looking for a yield between 4% and 10%, and a relatively cheap valuation based on metrics like P/E ratio, and AFFO (adjusted funds from operations) in the case of real estate investment trusts. Diversification across business sectors and geographic zones was also a priority. I subsequently got very busy managing the portfolio, and did not update it here on Seeking Alpha.

Income Segment: Replacing individual stocks with closed-end funds (CEFs) and ETFs

Since then, a lot has changed. Quite early in the process, several accidents with individual stocks highlighted the extreme volatility that can accompany dividend cuts or commercial operating problems. I concluded that given the level of income I was seeking, I should diversify away most of the individual stock risk by opting for closed-end funds (CEFs) or exchange-traded funds (ETFs).

Most of my income positions are now CEFs, which offer a complex set of advantages and disadvantages. On the plus side, they can often be bought at a discount to net asset value (NAV), pay high distributions, and are not required to sell assets at the bottom when investors rush for the exit. They can also cover a wide range of business sectors and geographic regions. On the minus side, management fees are high, and the business model of equity CEFs usually involves paying distributions that partly represent anticipated future stock market gains. This can work in moderation, but many CEFs go too far, and a lengthy period of market stagnation or decline can force a reduction in the distribution.

I still hold a few business development companies (BDCs), which although technically individual stocks, are essentially portfolios of middle-market loans plus some equity. I also maintain a cash reserve, held separately from the portfolio, that would allow a switch to full reinvestment of distributions should a lengthy market crash bring down valuations and cut distributions. A recent article covers reducing risk in high-yield income strategies.

Valuation plays: Mining stocks now dominate the segment

The valuation play side of the portfolio has also changed greatly because I’ve become increasingly more involved with the world of mining stock investments, regularly attending conferences and developing a set of filters to identify relevant opportunities. My preferences are for diversifying a mining portfolio across the different phases of projects, limiting holdings to mining-friendly jurisdictions, and being sure to take profits on the way up. Within the different project phases, I prioritize junior explorer stocks with a resource estimate, as they can combine reactivity to metal prices with tight share structures and undervalued market caps, maximizing upside. In addition to the miners, I have a very small position in Editas Medicine (EDIT), a biotech company experimenting with CRISPR gene-editing technology. A recent article covers reducing risk in mining stock portfolios.

Portfolio Summary

Hybrid Dividend Income Portfolio Summary Yield Performance. Overall net annual yield is 6.6% (previously 5.1%), while the yield of the income lines alone is 8.2% (6.9%). The improvement is largely due to the move from individual stocks, some of them blue chips, to CEF and ETF positions that offer higher distributions but also a higher (if calculated) level of risk. Note that the net annual yield statistics refer to the yield net of any withholding tax, but before any taxes in the country of residence.

Portfolio Value and Income by Sector

The portfolio is 80% income positions and 20% valuation play (speculative) positions. It can be broken down further by commercial sector or asset type, both in terms of position value and income generated.

The sector distribution of the portfolio is dominated (22%) by the "General High Yield Credit" category, which includes several US-centric BDCs and high yield credit funds with no particular sectoral focus, with these accounting for 26% of income. Real estate (11%) includes both equity and mortgage REITs, and generates 14% of income, while emerging markets equity represents 10% of portfolio value and 12% of income. The controversial MLP and CLO sectors are 8% of portfolio value but 16% of income.

Geographic Distribution

The income lines of the portfolio remain centered on the United States, which offers the deepest and broadest capital markets, and the most reliable record of sustained economic dynamism. Geographic diversification is provided by the emerging market funds at 10%, and the Europe equity fund at 8%, while several other positions, such as UTF, IGR and STWD, also hold substantial non-US assets.

Future Acquisitions

Future acquisitions are likely to focus on completing the Blackrock TCP Capital position, and opening a position in the Reaves Utility Income Fund (UTG), an infrastructure and utilities CEF with an extraordinary record of maintaining its distribution even through the last financial crisis. That is a rare achievement for a CEF, and may partly explain why the fund is currently on the expensive side.

Conclusion

The Hybrid Dividend Income Portfolio has changed greatly since I decided to diversify away most individual stock risk in the income segment by a shift to closed-end funds (CEFs) or exchange-traded funds (ETFs). The result is a higher yield and higher risk income segment that nevertheless retains strong diversification in terms of commercial sector, geographic zone, and fund management company. The valuation play (speculative) segment of the portfolio has been strengthened and diversified by the addition of several mining stocks, as well as a very small allocation to cryptocurrencies and biotech.

Disclosure: I am/we are long ALL STOCKS LISTED EXCEPT UTG AND GBTC. 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.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.