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Selecting Higher-Income, Lower-Risk Portfolios For Retirees.

Jul. 01, 2013 11:40 AM ETCSQ, AGD, DNI, ZTR2 Comments
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Portfolio Strategy, CEFs, ETF investing

Seeking Alpha Analyst Since 2007

My name is John Dowdee (also known as Dr D) and I have spent the last 30+ years as a program manager at a large aerospace company. I have a Ph.D in Engineering Science (mostly exotic math) together with a Master’s degree in Statistics and a Bachelor’s degree in Electrical Engineering. I started investing seriously in the 80s. I was a voracious reader and bought just about any book I could find on the stock market, futures, and economics. I finally realized that there was no "holy grail". However, using my statistics background, I did develop a technique for choosing investents based on their risk vs reward profile. I am now retired and use this technique to manage my retirement portfolio. I share this strategy on my website: www.superchargeretirementincome.com

As a retiree, I am continually looking for sources of high income but I also don't want to court excessive risk. This search led me to consider growth-and-income Closed End Funds (CEFs). These funds offer high income, typically over 6%, but what about the associated risk? This article will analyze selected growth-and-income CEFs in terms of their risk-to-reward characteristics.

Growth-and-income funds are also called allocation funds because they allocate their assets among both stocks and bonds. The funds are typically described as "conservative allocation" if bonds make up the majority of the assets and "moderate" to "aggressive" if equities are more than 50% of the total assets. The primary objective of these funds is to provide investors with a high level of income, with a secondary objective of capital appreciation.

Most of the distributions from these funds are managed, that is, they pay out the same amount each month. This makes it easier for retirees to budget but if the fund's assets do not earn sufficient dividends or interest to cover the entire distribution, then the shortfall is paid by using the fund's capital. This is appropriately called return-of-capital (ROC). ROC that reduces the NAV is considered "destructive". However, it should be noted that ROC also refers to profits received as a result of capital gains (as versus dividend or interest payments). If the ROC is a result of capital gains, it is not usually considered as destructive.

Most, but not all, CEFs use leverage to spice up returns. This is good in bull markets and when interest rates are low but could result in oversized losses when the bear or high interest rates return. The CEFs in this article, with the exception of the Zweig Total Return (ZTR), use leverage in the 20% to 30% range. ZTR does not use any leverage.

At the website, www.CEFConnet.com there were 13 CEFs in the "income and growth" category. For this analysis, I narrowed the list using the following criteria:

  • The CEF had to be relatively liquid, trading over 25,000 shares per day on average.
  • Distribution had to be greater than 6.5%.
  • The fund is priced at a discount to NAV.

The 4 CEFs that passed these tests are:

  • Calamos Strategic Total Return Common (CSQ). This moderate allocation fund currently sells at a discount of 5% and has a distribution of 8.3% paid monthly. The fund invests a little over half its assets in large cap stocks and the rest in high yield and convertible bonds. It has 204 holding with a relatively high expense ratio of 1.9%.
  • Delaware Investments Dividend and Income (DDF). This conservative allocation fund currently sells at a discount of over 9% and has a distribution of 7.3% paid monthly. The assets are partitioned between equity (about 50%) and bonds (high yield and convertibles). The equity includes dividend paying stocks, preferred stocks, and REITs. This fund contains 390 holdings and has an expense ratio of 1.5%.
  • Dividend and Income Fund (DNI). This is an aggressive allocation fund that currently sells at a discount of 11% and has a distribution of 10.5% paid quarterly. This fund is about 85% equities and only 15% bonds. It has 130 holdings and has a very high expense ratio of 3%.
  • Zweig Total Return . This aggressive allocation fund currently sells at a discount of over 10% and has a distribution of 8.3% paid monthly. This fund invests about 70% of its assets in equities and the rest in bonds (mostly treasuries). It has 82 holdings with the top sectors being financials and energy. Managers have the ability of using options on 10% of the assets to increase returns. The expense ratio is a low 1%.

Assuming equal weight, these CEFs average over 8.7% annual distributions so they definitely satisfied my desire for high income. To analyze risks, I used the Smartfolio 3 program (www.smartfolio.com).

Figure 1 provides the rate of return in excess of the risk free rate of return (called Excess Mu on the charts) plotted against the historical volatility over the past 3 years. The SPDR S&P 500 ETF (SPY) is also shown for reference.

Figure 1: Risk vs Reward: Growth & Income CEFs over 3 years

DDF and CSQ had performance that closely mirrored the SPY. ZTR had excellent performance, with a rate of return that exceeded the S&P 500 and with a volatility less than the S&P 500. DNI had the highest rate of return but also had the highest volatility. Before selecting DNI for my portfolio, I wanted to assess if the increased return was worth the increased volatility? To answer this question, I calculated the Sharpe Ratio.

The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio of the SPY. If an asset is above the line, it has a higher Sharpe Ratio than the SPY. Conversely, if an asset is below the line, the reward-to-risk is worse than the SPY. Since DNI is above the red line, I concluded that the increased reward was indeed sufficient compensation for the increased risk.

What would happen to the risk versus reward if I combined these four CEFs into a portfolio? In the 1950s, an economist named Markowitz made an amazing discovery. He found that if you combined certain types of high risk assets with low risk assets, you could construct a portfolio that had less risk than the components. His work was so revolutionary that he was awarded the Nobel Prize. One of the keys to achieving this is to combine assets that were uncorrelated with one another.

Figure 2 provides the correlation matrix associated with these CEFs. As you can see, the CEFs are relatively uncorrelated, with correlations typically about 30% to 50%. The only assets that are moderately correlated are CSQ with DDF (at about 70%). The CEFs are also relatively uncorrelated with the SPY so they offer a way to diversify your portfolio.

Figure 2: Correlation Matrix: Growth & Income CEFs 3 years

I combined these CEFs into an equally weighted portfolio, with each component equal to 25% of the total assets. The results are shown as the "yellow dot" labeled "portfolio" in Figure 1. The resulting portfolio has a total return of about 23% (40% higher than the SPY) with a volatility of a little over 14% (18% lower than the S&P 500). Over the past three years, this portfolio truly satisfied my objective of providing higher income with lower risk!

It should be noted that an equally weighted portfolio may not be the absolute best in terms of maximizing the return for a given volatility. The optimum portfolio is said to be on the "efficient frontier". However, the "efficient frontier" can change substantially with relatively small changes in input data. I prefer the simplicity of equally weighted assets, which are easier to rebalance over time.

This portfolio provided excellent results over the past three years but did it maintain its advantages over the past year, when the SPY was in a rip roaring bull market? To check the near performance, I plotted the data with a one year look back period.

As shown in Figure 3, the overall portfolio continued to perform well over the past year, with a return slightly higher than SPY and a volatility that was substantially less than SPY. DNI continued its high-return, high-volatility performance. The only CEF that did poorly was CSQ, which experienced low returns coupled with high volatility. Looking deeper into CSQ's performance indicated that, in 2012, the managers of this fund assumed that inflation would rise so they over-weighted inflation-sensitive sectors such as gold, energy, and materials. Inflation remained subdued last year so these bets did not pay off and the fund under performed. However, given the funds previous performance, I am willing to give the managers the benefit of the doubt and stick with the fund.

Figure 3: Risk vs Reward: Growth & Income CEFs over 1 year

Even though the volatility of this growth-and-income portfolio is less than the SPY, it should be noted that this portfolio still exhibits "equity-like" risks and should not be confused with a bond portfolio. However, if you can tolerate the risks, this portfolio may be worth consideration if you are searching for high income at a reasonable risk.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CSQ, DDF, DNI, ZTR over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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