How This Income Method Works Well In Good Times And Bad

Summary

• We regularly write about multi-basket income strategies. They mostly have the same underlying principles but vary in terms of income needs, growth goals, and risk levels.
• We wanted to analyze and give readers a view of how they would have fared during this unprecedented crisis if they were invested in one such diversified strategy.
• To remove the bias from results, we would assume that we started this strategy as of 1st January 2018, giving the strategy enough time to stabilize and then going into the current crisis. We will compare the results with the S&P 500 index.
• We also provide long-term back-testing results going back to 2008, which includes the 2008-2009 recession.
• Looking for a portfolio of ideas like this one? Members of High Income DIY Portfolios get exclusive access to our model portfolio. Get started today »

We regularly write about the importance of not only diversifying in stocks but also diversifying in terms of strategies and types of assets. As such, besides growth, we focus on income-producing strategies, especially strategies that also preserve capital during times of crisis. Preservation of capital is probably one of the most important factors for retirees and conservative investors. In order to preserve capital, it's important that our overall portfolio is able to achieve low volatility and smaller drawdowns, while not compromising on growth during the good times.

We can have all the talk about capital preservation, but the real test comes when the market takes a huge dive in real-time, something akin to what we have seen recently due to the coronavirus pandemic. An event or correction like this can act as a real eye-opener to review and judge if your portfolio is meeting its defined goals.

We wanted to analyze our three-basket strategy and give readers a view of how they would have fared if they were invested in one such broad-based strategy.

The strategy we will pick for testing and comparison is similar to one of our most popular from many articles that we have published in the past and can be found here, here and here. We will pick the beginning date of the portfolio as 1^st January 2018. The S&P 500 index was around the 2750 mark at the beginning of 2018, slightly below where it is hovering right now. Moreover, these past 28 months, even though not a very long time, does include two sharp corrections. The first one happened in the fourth quarter of 2018 but was followed by a quick V-shaped recovery. The second correction, of course, is the current one, which is still unfolding. As such, our benchmark is the S&P 500, so it does not matter much which date we pick since we are simply comparing our strategy vs. the S&P 500. Later, in the last section, we also will run the comparisons for the last 12 years, starting from the beginning of the year 2008.

Brief Description Of Three-Basket Strategy

We will assume that we invested $1 million of assets into this strategy, but the amount is not of much significance as it would work the same, whether it was $100,000 or $3 million. Normally, we advocate investing in any new strategy in small lots over a period of time (at least a year long). But to keep the calculations from becoming overly complex, we will assume that we invested the entire amount in one lump sum on the 2^nd of January 2018. For the sake of illustration, we will assume our hypothetical investor invests $1 million in our strategy, while another investor invested $1 million in the S&P 500 at the same time.

Basket Name	Type of Portfolio	%age Allocation	$$ amount allocation
Basket 1	DGI portfolio	40%	$400,000
Basket 2	Rotational RA portfolios (two portfolios)	45%	$450,000
Basket 3	8% High-Income portfolio	15%	$150,000

Click to enlarge

Note: Most retirees and conservative investors should also keep a cash-like bucket, however, the allocation could differ based on the individual situation.

Basket 1: (DGI portfolio 40%)

Now there are many ways to form a DGI portfolio, and this is the easiest part of the overall strategy. It's not hard to pick up some good blue-chip dividend-growing stocks. There are many models offered by Seeking Alpha authors here on SA, including our own "4% Passive DGI Core" portfolio. For a DGI portfolio, we usually suggest you select between 20 and 30 blue-chip DGI stocks with good dividend history from at least 10 sectors or industry segments of the economy.

In this analysis, we will not pick individual stocks. But we will just pick two Vanguard dividend ETFs, namely the Vanguard Dividend Appreciation ETF (VIG) and the Vanguard High Dividend Yield ETF (VYM). Both ETFs are very low cost and provide more than enough diversification. We simply could have provided the performance results from our “4% DGI Core” portfolio, which has performed better than the S&P 500 during this crisis. But that won’t be a fair apples-to-apples comparison because that's an active portfolio, and we buy additional shares many times during the year taking advantage of opportunistic prices.

We will keep these two funds in a 60:40 ratio, 60% for VIG, and 40% for VYM. Income investors (who need income today) could keep them in a 50:50 ratio or even 40:60 ratio, considering the fact that the latter provides high current yield. However, aggressive and younger investors who do not need income today should go for a 70:30 or even a 80:20 ratio. So there's a great flexibility that can be applied depending upon how much weightage you attach to dividend growth vs. high current yield.

As you could see from the chart below, that overall total returns (with a 60:40 VIG: VYM ratio) almost mirrored the returns of the S&P 500 during the last two and a half years. The story would be more or less the same if you were to go back to the year 2008. So, what's the advantage? The obvious advantage is the level of income this strategy can provide vs. the S&P 500. Also, as you progress in age, and start needing more income, you could allocate less to VIG and more to VYM to enhance the income.

For investors, who like to invest in individual stocks, one could just start with the top 10 holdings of VIG and VYM, there are a few duplicates though. We like and own a majority of these names.

Top 10 holdings of VIG:

Microsoft (MSFT), Walmart (WMT), Procter & Gamble (PG), Visa (V), Johnson & Johnson (JNJ), Comcast (CMCSA), Abbott (ABT), McDonald's (MCD), Costco (COST), Medtronic (MDT).

Top 10 holdings of VYM:

JPMorgan Chase (JPM), Johnson & Johnson, Procter & Gamble, AT&T (T), Intel (INTC), Verizon (VZ), Exxon Mobil (XOM), Coca-Cola (KO), Merck & Co (MRK), Pfizer (PFE).

Basket 2: (Rotational RA Portfolios 45%)

This is our hedging or insurance bucket, but by no means it's short on growth. In fact, the opposite may be true. We normally recommend adopting at least two strategies to diversify the risks. So, we are going to provide results from two separate RA strategies to prove that we just did not get lucky here, but these strategies invariably work. So, we will divide the basket dollars equally into two strategies (22.5% or $225,000 to each of the two strategies).

Basket 2 (Part 1) SPY/TLT Reverse Volatility Model

Note: We have a similar portfolio in our Marketplace service by the name of the "401K/IRA Rotation" portfolio.

This strategy aims for at least 9%-10% long-term returns with low volatility and minimal drawdowns. The strategy uses only two securities, the S&P 500 Index fund (SPY) and the 20-year Treasury Fund (TLT). The strategy invests and rotates between the two securities based on inverse volatility. The basic premise is that the lower the volatility in the S&P 500, the more of the investment dollars should be committed to stocks or the S&P 500, in this case. As the volatility in stocks or the S&P 500 increases, the strategy gradually moves money to the Treasury fund as a safety asset.

Some might say that Treasuries have been in a bull run over the last couple of decades and that it might not work the same way in the future. However, it's our belief that during a crisis and panic situations and sudden downturns, Treasuries always will perform reasonably well since investors find safety in them. This has been proven right during the current crisis as well.

Basket 2 (part 2) QQQ/TLT Momentum Model

This strategy aims for 10%-12% (possibly more) long-term returns with lower volatility and lower drawdowns than the S&P 500. The strategy uses only two securities, the Invesco QQQ Trust (QQQ) and the 20-year Treasury Fund (TLT). QQQ is an ETF equivalent to investing in the Nasdaq-100 Index. The strategy uses the Relative Momentum strategy and invests in one of two securities, which has had better performance over the previous three months. The process is repeated every month, and a switch is made between the two securities if necessary. Whenever the model senses problems with the Nasdaq-100 index reflected by consistent market decline, it switches to the safer bet of Treasuries. However, since this is a monthly rotation, there can be a lag. For example, this year, the market peaked on Feb. 19 before declining, our model switched to TLT as of March 2.

The performance of the combined portfolio (Rotational, part1 and part two) vis-à-vis the S&P 500 is as follows, assuming the same dollar amounts were invested as of 1^st January 2018. You can see that this basket provides an excellent hedge during times of crisis, as can be seen during Q4/2018, as well as going into the 2020 crisis. But it also provided the growth quite comparable to the broader market without the roller coaster ride. Income investors and retirees could withdraw 5% to 6% income from this portfolio at the end of each year. Since the drawdowns are very limited, a yearly withdrawal would not damage the portfolio as there is very little chance of sequential risk, compared to the S&P 500.

Basket 3: (8% High-Income Model 15%)

In this bucket, we usually recommend selecting one closed-end fund from each of the 10-12 asset classes that are available. In our articles on CEF funds and also, based on our "8%-CEF-Income" portfolio, these are the 10 funds that we would have selected. As a matter of fact, in our Dec. 2, 2017 article, we recommended these 10 funds. All of these funds have turned out to be excellent choices, except KYN (Oil & Gas MLP fund). So, here they are:

TABLE of 10 CEFs:

	Ticker	Fund Name	Type of fund/Asset class
1	PCI	PIMCO Dynamic Credit Income Fund (PCI)	Debt & Mortgage securities
2	PDI	PIMCO Dynamic Income Fund (PDI)	Debt securities
3	KYN	Kayne Anderson MLP (KYN)	Energy MLP
4	RFI	Cohen & Steers Tot Ret Realty (RFI)	Realty
5	RNP	Cohen & Steers REIT & Pref (RNP)	REIT/Pref
6	UTF	Cohen & Steers Infrastructure (UTF)	Infrastructure
7	JPC	Nuveen Pref & Income Opps Fund (JPC)	Preferred
8	STK	Columbia Seligman Premium Tech (STK)	Technology
9	NMZ	Nuveen Muni High Inc Opp (NMZ)	Municipals
10	HQH	Tekla Healthcare Investors (HQH)	Health Care

Click to enlarge

We will assume that we invested in these ten funds equally for this basket as of the 1^st of January 2018. Now we will compare the performance of this portfolio with the S&P 500 from 1^st January 2018 until now (April 25, 2020). This bucket had an excellent run until February this year. But as of now, it's lagging the S&P 500 quite a bit, primarily because of a nearly 60% loss in KYN (Oil & Gas MLP Fund). In fact, excluding KYN, the performance would be at par or slightly better than the S&P 500. That said, this portfolio does not provide any downside protection, and that’s why we recommend an allocation of no more than 25% but preferably less. The only purpose is to boost the overall income of the portfolio.

The Combined Portfolio (all three baskets)

The below graph shows the performance comparison once we combine all the three baskets as one portfolio versus the S&P 500. The combined portfolio had a starting capital of $1 million as of 1^st January 2018. As you can observe, the volatility and the up and down movements in the combined portfolio increased when compared to the Rotational portfolio alone, but still much better than the S&P 500. In addition to less volatility and drawdowns, the growth of the combined portfolio is superior (or at least matching) to the S&P 500 during both the bull period and the bear period.

Back-testing from January 2008 until now

We know some would question the wisdom of showing the performance and comparison of only about 27 months. We provided a shorter window as it's easier to relate to the recent period. That said, we will provide a longer back-testing example as well, with the same model going back to the beginning of the year 2008. So, now we would assume that we started this three-basket portfolio as of 1^st January 2008, so as to include the 2008-2009 recession.

We will provide the back-testing results starting from 1^st January 2008 until March 31, 2020. Though we can test the bucket 1 and 3 (DGI and Rotational) without any issues, we will run into issues with the High-Income CEF portfolio due to two securities, namely PCI and PDI. These two PIMCO funds did not start until 2013. If we assume that we invested a total of $100,000 in the three-basket portfolio, we would have invested only about $15,000 in the CEF-portfolio and only $3,000 in PCI &PDI. For the purpose of back-testing, we would assume that we invested $3,000 in another PIMCO fund, PIMCO Corporate & Income Fund (PTY), from 1^st January 2008 until 31^st December 2013, after which this amount was moved to PCI and PDI. PTY is a different kind of fund than PCI/PDI, but that would not have changed the outcome much.

Please note that how the green and orange linear lines are diverging over time, indicating that over a long period of time, the three-basket portfolio outperforms the S&P 500 while avoiding a roller-coaster ride at the same time. Over a 12-year period, the three-Basket portfolio achieved a 55% outperformance compared to the S&P 500 with 30% less volatility.

Now let’s see how each of the baskets performed within our three-basket portfolio.

Concluding Thoughts

In the last two years, we twice had a serious market decline. First, a near 20% correction during the fourth quarter of 2018 and now a 35% correction this year in Feb./March period. Even though the markets have pulled back up more than 25% from the lows of March 23, they are still down roughly 16%-18% from the peak. The current situation is still ongoing, and many of the outcomes from the economic shutdown due to the coronavirus pandemic are still unknown.

The investing community is kind of divided into two camps right now. There's a large and vocal camp that believes the bear market is not over yet and, in fact, has just started. They believe that the market has much lower to go from here. We see a large number of articles subscribing to this view on SA day after day. Then there's another camp that believes that we are likely to see a V-shaped recovery albeit largely made possible by huge amounts of stimulus unleashed by the Fed and the US government. It's hard to say who is right. There's a third path, of course, and more likely that the market just muddles along and stays between 2500-3000 level (S&P 500) for the next several months before we know how the economy fares and if there is a second wave of the pandemic on the onset of next winter season.

Obviously, we have no special crystal ball to know the future. But we are reassured with the thought that whatever the markets may do, whether they go up, decline from here or stay flat, our diversified multi-basket portfolio will perform reasonably well in good times and bad. Sure, if the markets decline big time, our buy-and-hold portfolios will decline as well, but most of their dividends will not. Also, that may be an opportunity to add to some of the positions. Our hedged part of the portfolio (rotational) will cushion any downside impact, in fact, may go up in values during a serious decline. We have presented a view of the past two years of how our multi-basket model has fared and how it can provide peace of mind during the crisis while not being short on growth during good times.

Analyst’s Disclosure: I am/we are long ABT, ABBV, JNJ, PFE, NVS, NVO, UNH, CL, CLX, GIS, UL, NSRGY, PG, KHC, ADM, MO, PM, BUD, KO, PEP, D, DEA, DEO, ENB, MCD, BAC, PRU, UPS, WMT, WBA, CVS, LOW, AAPL, IBM, CSCO, MSFT, INTC, T, VZ, VOD, CVX, XOM, VLO, ABB, ITW, MMM, LMT, LYB, ARCC, AWF, CHI, DNP, EVT, FFC, GOF, HCP, HQH, HTA, IIF, JPC, JPS, JRI, KYN, MAIN, NBB, NLY, NNN, O, OHI, PCI, PDI, PFF, RFI, RNP, STAG, STK, UTF, VTR, WPC, TLT. 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.

Disclaimer: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. The author is not a financial advisor. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the author does not claim 100% accuracy. The stock portfolios presented here are model portfolios for demonstration purposes.

Comments

[NV_GARY]

@Financially Free Investor
"For example, this year, the market peaked on Feb. 19 before declining, our model switched to TLT as of March 2."

It looks like QQQ was doing the best in the 3 months prior to your switch- why go to TLT?

thanks
G

[Financially Free Investor]

@NV_GARY Thank you for reading and the question. So, that's not correct. At the end of February, over the previous 3 months, TLT was showing >10% gain, while QQQ was up less than 1%.
It was entirely possible, that the downturn would have started on 1st of March, then we would have waited an entire month to switch. But then in the long term, these things sort out themselves.
Thanks.

[Pacman13]

Thank you for your work here. I like the concept. Perhaps I am missing something though. If the Basket 2 using QQQ/TLT and SPY/TLT gets 9-12% returns, why would you use the Bucket 3 of CEFs with target of 8% with as mentioned no downside protection? It may be difficult to get 8% income but I think using preferreds and some fixed income vehicles you could get 6% with significant less risk.

[KKane]

Thank you for the well written article. what assumptions did your analysis make about the income the combined portfolio made? Did it sit in cash, or was it reinvested? If reinvested, I am curious how and when.

Thanks again.

[5992321]

@Financially Free Investor Thanks for the article. Nice approach, with quite limited volatility, which I think is appreciated by more investors given the events of the last 60 days. Two questions: (1) have you thought about using preferred shares in place of the CEF portfolio? They (typically, if wisely chosen) produce very stable income and generally have pretty stable prices as well. (2) is there a mutual fund (or ETF or CEF) that executes the rotational strategy? The reason I am asking is that I think there are behavioral economics issues that can sometimes make it difficult to pull the trigger on the rotation at times, but having some other mechanism do it automatically for you might be helpful. It would also help when we get older and perhaps have less cognitive capacity (or die and leave the assets to someone who is less financially savvy). I suppose there are some automated mechanisms offered by some brokerages that might do the trick too. But my preference would be to find a low cost mutual fund that does the rotation for me. Any thoughts?

[Doctor Mike]

@Financially Free Investor, thank you for a clear and helpful article. Can you give us the "neutral" setting for basket 2, and the ranges you go to for the two securities (e.g. 30-70)?

Thanks.

[riddix]

Why is NMZ classified as a utility ?

[Financially Free Investor]

@riddix - It is by mistake, needs to be municipals. Thanks for pointing out.

[Nick Ackerman]

Interesting how that is the first thing I noticed too and then was the first comment I saw. hah!

@Financially Free Investor good article and interesting portfolio setup!

[GoRetireSmart]

@Financially Free Investor Thank you for the well thought out and interesting article! I have one question though. In looking over the performance of the three buckets, why not just be 100% invested in bucket #2 (RA strategy)? That seems to give the best overall result with the least volatility. Why include the other two buckets if one does only a single yearly draw-down/withdrawal?

[Financially Free Investor]

@GoRetireSmart - Thank you for the comment. Just the old saying "don't put all your eggs in one basket".. Future can be different than the past. But I would say this. In my opinion, the first two buckets are very good in the long-term, and each has distinct advantages. The only bucket that can be optional is the CEF-income if one does not need or care about income.

[Arbitrage- Technologies]

some cohen and steers fund RNP and others distribute 9pc div. how is that possible when average underlying distribute aorund 6.5pc??? be carefull

[Fast Track to Financial Independence]

That's the equity CEF business model. The difference comes from leverage, and/or option-writing, and some dose of distributing tomorrow's stock market gains today. The latter can work in moderation, but is disastrous in excess.

[El Contador Inversor]

Certainly don’t know whether we will get another market dip or a V recovery. However went to Home Depot this morning. Parking lot was absolutely packed. During this entire process they’ve been open but nothing like today’s crowds. Sure seems to be pent up demand.

[Kyed]

Thanks for an very interesting and well researched article.

Withdrawing about 5- 6% per year okay, but some of those assets pays dividend as well, so I don't quite understand it? Is the 5-6% withdraw including the dividend.

Thanks.

[Financially Free Investor]

@Kyed - Yes, that would include dividends or distributions. Thanks.

[seek2945]

In your Basket 2, Part 1 how are you measuring volatility?

[Financially Free Investor]

@seek2945 - We measure the volatility of the two securities over the previous one month. Volatility measurement is the "standard deviation" of the daily variations over the specific period. Thanks.

[seek2945]

Thank you.

[ruediklein]

Good article. Coming from twenty years of cap-weighted global indexing with little to show for, I have looked at the Income Factory and your bucket approach and have settled on the buckets. Since I started investing in the high yield portion end of last year and really getting into it in the short run-up in February, I have been taken to the cleaners.
The high yield portion is the riskiest part of the buckets. It therefore makes the most sense to actively manage it, i.e. rotate out of, when the potential loss exceeds the 8-10% yield, wouldn‘t you agree?
Further, I am wondering who this portfolio approach is for? Surely, the folks on SA won‘t sit around evaluating their portfolio only once a month, when all hell just broke loose? Instead, when things are volatile weekly monitoring and action would improve the performance.
As such, one could improve on the rotation indicator as well, perhaps a combination of Trend Following and STC would have gotten one out before any significant losses.
Stay safe, Ruedi

[Financially Free Investor]

@ruediklein - Thank you for the comment. I agree, in our 3-basket system, the High-Income (CEFs) is least safe and has no downward protection. That's why we recommend allocating a small portion of your portfolio. So, the question is why to allocate at all? The idea is to generate a lot of income from a small part of the portfolio.
Btw, our CEF-portfolio is down -21% YTD compared to -11.60% for S&P500. But if you exclude the MLPs, it is in much better shape. Our DGI is down -9.80% YTD. Our Rotational portfolios are either in positive territory (as much as 20% up) and a couple of them are negative by just 2%.
So, it is important to mix them in the right proportions to make the overall portfolio conservative and safe. Hope this helps.

[John R. Clark]

Good day to all. Thanks again to our host author for a key quote with application beyond the scope of today's feature. Namely, "Preservation of capital is probably one of the most important factors for retirees and conservative investors."

My own self calls it definitely THE most important, given how the more capital you lose or waste, the less remains to generate future income. As for young investors who took paper losses in this year's crash (like all the rest of us), but stood fast instead of panicking --- many compliments. You hold the same capital or assets as before, only with diminished value for now. Keep it, PRESERVE it, add to it, and your capital will again multiply.

Proverbs 13:11 (New English Bible) reads:

"Wealth quickly come by dwindles away,
but if it comes little by little, it multiplies."

Some translations open with "dishonest gain" --- ignorantly in my view, as if sudden wealth never came by lawful means but only from cheating and stealing. Who hasn't heard of life insurance, inheritances, gifts, timely invention of, say, the Hula Hoop, timely purchase and sale of Hula Hoop shares, or just picking the right lottery number?

So be it for now. We all know of someone who came upon a large sum only to lose it all from ill- preparedness. Yet this proverb, correctly read, not only states the nature of a thing but also instructs how to thwart its tendency. First, be mindful of that. First also, don't wait or dream for sudden wealth, but build your own little by little. This is all most people can do to start, via a 401(k), IRA, or similar means. But this works when you do it. This also teaches you how greatly a large sum ever received would multiply if placed and held right. Wealth quickly come by need not dwindle.

Ideally, parents would teach their youngsters the virtue of thrift and saving, without leading them ever to count on a monetary windfall. In reality, many adults will receive their first wise counsel from a mentor, co-worker, friend, or remote trainer such as Dave Ramsey. From whomsoever, this never comes too early and better late than later. I have been privileged to advise 4 or 5 parties on financial choices, mostly related to spending.

In a household keeping life insurance to support a widow(er) and orphan(s), the spouse in charge should make sure of the other's being grounded in basic finance, with names of several reputable parties to call for help. Money acquired this way can dwindle fast from unpreparedness, or when used rightly will serve as a base for ever- growing wealth.

A balanced financial portfolio, built and well tended over decades, with or without sudden increases, makes great assurance for one's best years.

Thanks to all for reading. Keep wise and well!

[Financially Free Investor]

@John R. Clark - Thank you for sharing the wisdom. All the best.

[Reagan10]

Good article. What do you think about using ETJ or one of the Eaton/Vance funds to help limit the downside in Bucket3.

[galicianova]

Truly nice and simple!

[Financially Free Investor]

@galicianova - Thank you for reading.

[Flashback9]

Good work. Thanks for writing this.

[Financially Free Investor]

@Flashback9 - Thank you for reading. All the best.

[cm schwab]

Very nice read thank you for posting. 🙂👍

[Financially Free Investor]

@czbbcl - Thanks, appreciate the comment.

[tulasubway]

I just upgraded to Premium. Does that mean I get the key to the acronyms? DGI? RA?

[Financially Free Investor]

@tulasubway - Thank you for the comment. I am sure you will get used to DGI (Dividend Growth Investing) very soon, as it so commonly used on SA. However, RA is just a term used for Risk-Adjusted in the context of Rotation strategies, I guess I used the full form also in the article. Best.

[gastank]

Thanks for sharing.

[Financially Free Investor]

@gastank - Thank you.

[Diamond-Hands]

Awesome article with good data to back it up.

Not sure I am conservative enough to adopt this plan, but given my disastrous results this year, maybe I should.

[Financially Free Investor]

@$Das Kapital - Thank you for the comment. All the best.

[12tb3]

The title of the article says it’s an income method but I didn’t see anything saying the returns were calculated assuming any income withdrawals. I’d like to see the analysis including monthly withdrawals similar to what a typical retiree may desire, say like 4%, 5%, and 6% ($40K, $50K, $60K annually). I think it makes a significant difference in the performance when these distributions are not being reinvested.

[Financially Free Investor]

@12tb3 - Thank you for the comment. We did not include the graphs with income withdrawals, in order to avoid the article getting too long. But there are links to 3 previous articles which include income withdrawal examples. One can comfortably withdraw 5% income (maybe even 6%) from this strategy without impacting the portfolio performance/growth. The reason this strategy can handle income withdrawal much better than S&P500 is the lower volatility and much smaller drawdowns. Hope this helps. All the best.