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Posted by on Aug 13, 2014 in ETF Strategist

You’re Gonna Need A Bigger Bucket

You’re Gonna Need A Bigger Bucket

By Roger Nusbaum AdvisorShares ETF Strategist

The title is a nod to Shark Week and the movie Jaws but this post would be better titled You’re Gonna Need Another Bucket. It was inspired by an article in Barron’s over the weekend about an new income vehicle called a yieldco which is sort of like an MLP from a solar company whereby they spinoff the cash generating portion of their business. For example one yieldco highlighted is a spinoff of a solar energy-generating farm. That business has cash flow which can generate yield to shareholders.

These are not MLPs but some are being structured with an apparent eye to reclassifying into MLPs at some point in the future. This is ground we’ve covered before from a bigger picture viewpoint in noting the need for income vehicles and where there is a need there will be a solution or an attempt to offer a solution anyway.

At a minimum, investors think of at least three asset classes; stocks, bonds and cash. Many also consider commodities to be an asset class that merits consideration in a diversified portfolio and some folks will think of REITs as a distinct asset class and maybe alternatives as well.

In recent posts we’ve talked about income vehicles that take on equity-like volatility or beta or at the very least have much more volatility than goes with the more standard plain vanilla bond and of course longer dated bonds will increase their volatility dramatically if/when interest rates normalize.

Now, marrying together the two concepts of different asset classes and income vehicle volatility leads to the idea of a different income bucket for a portfolio that is distinct from more traditional fixed income. This is not a new idea but may be taking on more importance as a larger percentage of market participants will be looking for yield to live on as they get older. Also even though we talk a lot about the 4% rule for portfolio withdrawals the reality is that with so many people under-saved and so will take more than 4%.

This bucket would include things like REITs, MLPs, closed end funds, CanRoys, high yield bond funds, infrastructure trusts and other things that come along like yieldcos. They generally carry more risk or are more volatile so they have higher yields than things like investment grade corporates or sovereign debt.

These vehicles will also look different than plain vanilla bonds.

Clearly many people do this sort of thing already but maybe they include this in with their equity allocation but I would make this bucket distinct from the regular equity bucket because most of the yield vehicles will have a low correlation to equities at least on the way up. On the way down these vehicles will have a likelihood of falling faster than equities, but these things tend to not look like equities (repeated for emphasis). I would stress that I envision this as probably adding volatility to the portfolio not reducing it. While any single company can fail, and I do mean any company, the odds of a failure decrease when the company’s product can’t be made obsolete like film for a camera or can be grossly mismanaged like a financial institution. A maker of candy bars or laundry detergent is less likely to go out of business; stocks of these companies could struggle for years but failure is a lower probability.

And of course an index fund will not go out of business. It will go down a lot in the next bear market and then come back to make a new high with the variable being how long that takes. The same is less easily said about income vehicles like the ones mentioned above. If fracking ever ends that could be a deathblow for the MLP that is based on fracking sand.

Anyone pursuing a non-traditional income bucket will probably want to actively manage these positions closely. This can be as simple as a moving average or a crossover but just like equities will again have a bear market at some point a lot of the market segments in the above paragraph will fall more than the broad market when that next bear comes. Collecting 8% from a CEF for three years won’t do much good if it is sold in a panicked fashion after it falls by 2/3rds.

The risks here are along the lines of chasing yield but understanding this going in and have a strategy for selling should reduce the consequence. Also, yield chasing is associated with people not realizing the risk they are taking whereas this post could be thought of as a flashing yellow light which of course means proceed with caution.