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Posted by on Aug 7, 2014 in ETF Strategist

Income Investing Evolves, Volatility Doesn’t

Income Investing Evolves, Volatility Doesn’t

By Roger Nusbaum AdvisorShares ETF Strategist

Earlier this week I stumbled across and article at Seeking Alpha about an actively managed income portfolio that the author appears to have first posted in May with the article I found having been the second update. It looks like he made a trade or two in the first update.

The most recent article in the series is to give an accounting of the portfolio after last week’s drop in the equity market. He noted that the portfolio fell 2.14% versus 2.69% for the S&P 500—the author also included results of some other equity index benchmarks.

I am not linking to the article or mentioning any of the tickers he included because the point here is not to criticize the portfolio but to explore what might be a new reality with income portfolios. Notice I am not saying fixed income portfolio but income portfolio.

The old time treasury ladder or allocation consisting only of investment grade bonds is not necessarily the ideal solution for too many people these days due to how low interest rates are and the potential for the wrong kind of volatility if/when rates normalize.

The author above realizes this and has constructed a portfolio that addresses at least some of that dynamic; insufficient yield. He does however take on some equity beta (equity volatility). Whether anyone would be ok dropping 2.14% in a down 2.69% world is an individual tolerance issue with no single right answer. Obviously there is a potential problem if someone is blindsided that result.

The extent to which some income vehicles tend to look like equities is something that can change. The portfolio that the author put together includes an ETF that owns closed end funds. While the yields tend to be pretty good for closed ends they usually don’t have a whole lot of equity-like volatility on the way up but on the way down they can flush very quickly even more than equities depending on the circumstance.

A T-bill ETF or maybe one of the money market-proxy ETFs will never look like equity unless the sponsoring fund company has some sort of problem with its own solvency along the lines of the Bear Stearns ETN from during the financial crisis. From there each segment of the income space will have its own volatility profile but again it really doesn’t matter what that profile is on the way up as opposed to on the way down.

An ETF that owns utility stocks should not be expected to keep up with equities in a full year like 2013 but over course during the “taper tantrum” of May and June of 2013 the typical utility sector ETF fell much more than the broad market.

This is an idea that we have explored here over the last couple of months as the manner in which people build the fixed income portion of their portfolio may have to change—it appears to be changing. And while that will mean different things to different people it feels like a universal reality that investors (professionals and do-it-yourselfers alike) will need to confront the volatility profiles they are taking on and invariably there will be investors (professionals and do-it-yourselfers alike) that will learn they took on more equity-like volatility than they realized.

The point is not that equity volatility is bad for an income portfolio, obviously someone who only wants to own dividend stocks has equity beta but they need to understand that the next time the stock market cuts in half their portfolio could still drop 30-40% if not more. Now extrapolate that idea to a portfolio that is heavy in closed end funds, MLPs and REITs. There is plenty of equity-like volatility there, especially during declines which is the important thing.