Almost no other category of investing has experienced as much turmoil in the last 12 months as income investors have been subjected to.
Interest rates have been on a roller coaster ride that has churned the landscape for core themes in fixed-income, REITs, preferred stocks, and even dividend paying equities. Years of low volatility in many of these categories had lulled income seekers into a false sense of security that led to jolting changes in a short period of time.
Fortunately, we have seen stabilization in interest rates this year and fears of a stock market collapse have yet to materialize despite the best efforts of “top-calling experts”. Now that we just closed out the first quarter, this is a perfect time to review your statements and assess the strengths and weaknesses of your portfolio. Through this analysis, you may find areas that can be adjusted to enhance your returns for the remainder of the year.
Here are five essential strategies for ETF income investors.
#1 Lower Your Average Fixed-Income Duration
You have probably heard the call to lower the average duration of your fixed-income holdings for some time now, but many investors are still finding themselves in the upper end of the yield curve. That makes your portfolio more sensitive to fluctuations in interest rates which could prove to be a mistake if we see rates move higher this year.
One alternative ETF that you may want to consider is the Vanguard Short-Term Corporate Bond Fund (VCSH) which invests in a portfolio of 1-3 year duration investment-grade fixed-income. This ETF has been steadily rising over the last six months and will be less sensitive to changes in interest rates than a similar fund with higher average duration.
Another strategy to consider is moving to an actively managed mutual fund that is focused on interest rate risk and had success navigating those waters last year.
#2 Resist High-Priced Junk Bonds
Domestic high-yield bonds (otherwise known as junk bonds) have had a tremendous ride over the last several years. Low default rates and a thirst for yield have been tremendous drivers of asset prices in this sector. However, valuations have appeared to reach an extreme level,which has in turn led to lower yields for new money being added to this space.
If you already own a junk bond ETF such as the iShares High Yield Corporate Bond ETF (HYG), I would continue to hang onto the position with the expectation that we may see a shift in credit at some point that would necessitate an exit from this holding. Prices are not indicating any kind of problem as yet, and the income streams are still solid for early adopters. However, there will come a time when it will make sense to switch to higher credit quality areas such as investment grade corporate bonds or mortgage securities.
One possible alternative that I believe is offering a more attractive value proposition with a comparable yield is the iShares JP Morgan USD Emerging Market Bond ETF (EMB). This ETF sports a yield of just under 5% and is still trading below its 2013 highs.
#3 Broaden Your Horizons to Include Innovative Income Strategies
The search for yield can take many forms and some investors are focused on one thing — high monthly dividends. If that is your primary objective, one new ETF that I believe offers a unique strategy is the YieldShares High Income ETF (YYY). This ETF is a “fund of funds” that invests in a basket of 30 closed-end funds with both equity and fixed-income holdings.
The 30-day SEC yield of YYY currently stands at 8.38%, and dividends are paid monthly to shareholders. This unique multi-asset approach offers a strong dividend stream and diversification in one package for aggressive income seekers.
#4 Look Overseas for Higher Dividends
As domestic equities hit new highs, many yields on equity-income funds have fallen significantly due to the price appreciation of the underlying securities. To combat this effect, income investors may want to consider an ETF such as the iShares International Select Dividend ETF (IDV).
This fund currently pays a yield of 4.64% and has exposure to 100 dividend stocks of foreign developed nations. Top country weightings include: Australia, United Kingdom, France, and Germany. The significantly higher yield and diversification outside of the U.S. make IDV an attractive dividend-paying equity holding with the potential for additional price appreciation.
#5 Reduce Cash Holdings
Cash can be used as a short-term hiding spot from the sale of an asset or shelter from the storm. However, hiding out in cash for an extended period of time can significantly hurt your returns because it is paying next to nothing. This is especially true when asset prices are continuing to trade well this year.
If you have a high cash position, you should put that money to work in areas that will allow you achieve your income and growth goals. Even a short-term bond fund can produce a modest monthly income stream without taking excessive risk.
Consider pairing equity, fixed-income, or even alternative asset strategies to balance your portfolio and mitigate specific risks in any one asset class. This can help smooth out volatility and increase your total return over time.
The Bottom Line
Income investors have faced a number of unique opportunities and risks over the last year which has required flexibility to adapt as conditions change. Fortunately there are a number of excellent choices available through exchange traded funds to access specific themes and avoid potential obstacles. I recently discussed a variety of correlations and opportunities in this video presentation that point out specific trends we are monitoring moving forward.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities.
Learn More: Why I love ETFs, And You Should Too