Focusing On Portfolio Construction: A Response To Recent Comments

Last week, we published an article titled “Record-High Stocks, Record-Low Yield: What Should A Retirement Investor Do?” The response it elicited in the comments section was surprising. Many of the comments centered around the lack of actionable content. In my summation, most readers don’t want to learn but instead want to be told what to buy. That is an invitation for disaster, in my opinion.

For instance, this comment:

You’ll note it says specifically that it “doesn’t say what to buy. Doesn’t allocate. Does waste time.” But the comment throws out a generic portfolio that may work for them but not someone else. That’s the point I’m trying to make EXACTLY.

Again, the article is not another of the multitude of Seeking Alpha articles telling you to buy this, buy that, sell this. In my estimation, most of those articles are the ‘waste of time.’

The main issue with do-it-yourself investing remains the lack of a game plan. The mindless buying of random securities because there was someone they follow recommending it on the platform.

The goal of the article was to discuss how to de-cumulate in today’s environment. Too many investors are simply looking at putting together a hodgepodge of assets together into what they believe is a portfolio for their future. But, too often, these securities are all high risk with little thought on how they fit together. Almost no consideration is made for risk.

For some, it may not be feasible to live off of gains and interest/dividends like they have in the past. That is because future income, either from dividends or lower bond yields, will be meager.

We offered up a few solutions to this problem:

(1) The investor could simply reduce their lifestyle. William Bengen was one of the first to articulate the 4% withdrawal rate rule back in the early 1990s. But that was based on a higher rate of interest earned on your bond portfolio. In addition, future returns for equities looked much stronger than they do today using the earnings yield. Many investors will have to reduce their withdrawal rate from 4% to 3% or even lower.

The other solutions all rest on taking more risk. Again, there is no free lunch to the solution.

(2) We discussed focusing on cash flows. In our service, we do that by placing the Core Portfolio at the center of your portfolios. Think of a model-of-models where the Core is simply one of the pieces in that overarching umbrella or puzzle. That Core helps produce the income we need for retirement with an 8%+ distribution yield. That doesn’t come free in a sub-1% world. For some, however, a focus on cash flow production involving an adaptive approach of harvesting gains in appreciated positions will be needed.

(3) Lastly, a high yield equity-like portfolio where you take more risks and produce higher returns. The investor will, of course, need to be able to weather the volatility. This removes the need for inconsistent capital gains to be part of the solution.

Income Production

The goal by the portfolio manager is to pay out the highest yield possible while keeping the NAV steady or higher. If they can do that, then the investor can rely on the higher income stream without having to manage it themselves.

A closed-end fund (“CEF”) can produce income in multiple ways. The first is, simply, the income generated by the underlying bonds in the portfolio. That interest earned can be spread out to be paid on a monthly basis like most CEFs.

The second is to pay out some capital gains. This can be either short-term or long-term capital gains. Lastly, if there are no gains in the portfolio, then the payment is just a return of capital.

A focus on cash flows could look just like this managed distribution policy from a CEF. This is a combination of net investment income and gains, as well as return of capital – essentially, a focus on cash flows under option two above.

When Building An Asset Allocation Framework

We have a lot of resident members who are what we call “resident experts” – and could really have their own marketplace services as well. One of our top posters regularly shares his knowledge, his portfolio, and his insights both on the main chat and via direct messages to other members.

Below is the way he chooses to manage his portfolio. Also, this is a larger portfolio. With a larger portfolio comes greater flexibility.

What you will see is a keen focus on cash flows. The entire objective of his portfolio is to generate income. The excess income is reinvested and compounded once he reaches his spending threshold.

Some observations:

  • Macro focus: You can see he breaks down the portfolio at the macro level. This is the way he thinks about portfolio construction. There is a primary consideration given to what asset class or sub-category he wants to invest, and then, he hunts for the proper vehicle.
  • A Focus on Risk: His equity bucket – just over one third of his total portfolio – has two key characteristics: income and risk mitigation. His larger positions are covered call-focused funds that help produce greater income than a plain vanilla stock portfolio and help reduce volatility.
  • Positions like Eaton Vance Risk Managed Diversified Equity (NYSE:ETJ) is a great example of that combination of income production and risk mitigation. The fund employs a collared options strategy (sells calls, buy puts) in order to “lock-in” a certain rate of return (as best they can).
  • Another great fund is the Aptus Defined Risk ETF (DRSK) which attempts to stay with the S&P 500 but with only a fraction of the downside potential. We recently highlighted this fund to members and are impressed with the strategy and management.
  • Hedges: Another item you will notice is that they have some devoted hedges. For the member, he has approximately 10% of the portfolio in gold. This has worked very well in the last six months and has “done its job” with flying colors. He also has a large cash balance and what I would call a “cash-plus bucket.” This is nearly one-quarter of the portfolio and has a yield of just over 1%.
  • My hedging portfolio is a bit different. I primarily use put options on SPY and HYG to reduce the risk of my closed-end bond funds. The SPY puts tend to hedge against discount widening while the HYG puts tend to hedge against NAV declines. I also have a decent position in iShares Gold Trust (IAU).

Why do I show this? Not as a model that should be copied by everyone. No. It is to show one of the proper ways for thinking and constructing a portfolio for certain people. The owner isn’t putting together a hodgepodge of different funds and securities with little consideration for correlations and how the pieces fit together. Instead, risk is a key factor as well as a contrarian investment strategy. That is quite obvious with his investment in the Energy Select Sector SPDR (XLE).

I wouldn’t be purchasing ETJ today, given the 2%+ premium to NAV. But be patient and wait for your entry point. But even his equity allocation focuses squarely on risk mitigation.

Instead, look at the following options:

A Few Options To Consider

The key here is to consider whether you are a “risk on” or “recovery bull” investor or a “L-shaped recovery” investor. The former means that you are likely to be taking more risk in your portfolio. The latter is likely playing a bit more defensive.

In my portfolio, I have a mix of the two. For risk on, I have many positions (including those listed below) that are juicier positions. What I would call bond octane. But I also have some investments in case the recovery stalls and we double-dip back down.

Risk On: Gabelli Convertible and Income Securities (GCV)

One fund that we recently highlighted was Gabelli Convertible and Income Securities. The fund offers hybrid exposure, meaning it sits in the grey area between bonds and stocks. The fund is definitely in the “risk on” group.

What am I looking for here?

  • Solid management – Gabelli is a top fund company with a strong long-term track record.
  • Wide discount providing a good entry point with the potential for capital gains. I love when the price has trouble keeping up with a fast-rising NAV.
  • Solid yield at 8.60%, though it is paid quarterly. The distribution is unchanged for nearly 10 years.
  • NAV has fully recovered from its February highs. Additionally, the NAV trend is very strong.
  • One-year z-score is -1.10, indicating some moderate cheapness. Towards the end of 2019, the fund traded at a 5% premium. It is now at a -6% discount.

GCV along with Bancroft Fund (BCV) are my two “go-to” convertibles funds. The Gabelli fund is a bit lower risk (and lower yield) compared to BCV, but BCV offsets that with better performance.

Risk On: Eaton Vance Tax-Advantaged Global Div Opp (ETO)

Another “risk on” type of income trade. The fund is currently sitting at an -8.4% discount, in the lowest 5% of observed discount observations. In other words, it is trading very cheap at the moment. You can see that valuation shift in the premium/discount chart below. A year ago, the fund was trading at an approximate 10% premium. That is a dramatic shift.

(Source: CEFConnect)

The reason for the decline is likely the distribution cut done in May. The fund reduced the payment from $0.18 to $0.1425, a reduction in income of 20.8%. But these funds do not earn their distribution anyway. In fact, the May section 19a notice showed just 15.4% of the distribution was earned with net investment income. Instead, the fund makes up for it by returning capital to you – mostly in the form of long-term capital gains (hence, the tax advantage in the fund name).

So, an investor should really be indifferent to the fact that the distribution was lowered. The earnings power of the fund is relatively unchanged. You could always “recreate” the prior distribution by selling some shares (especially now that trading commissions are free).

We think the fund is very cheap and offers up “equity lite” exposure with some potential upside from the discount tightening. The discount tightening potential is on the higher side of what we can find today at approximately 5-6 points.

Risk Off: BlackRock Municipal Bond (BBK)

This is a tax-free muni CEF that has been on our “Conviction List” for quite some time. BlackRock seems to be doing everything right when it comes to municipal bonds, and we continue to like that sponsor over Nuveen (although Nuveen has made up some ground recently).

The fund pays 4.71% tax-free, which, if you are in the 24% tax bracket ($165K-$250K) of joint filing income, equates to a 6.20% tax-equivalent yield. The fund recently increased the distribution to $0.0610 from $0.0560. It was the second increase in the distribution in the last six months. We think the payment is very safe.

Adding muni bonds provides a natural hedge to the portfolio. While they certainly can fall in a time of panic, they tend to be very credit risk safe.

  • The portfolio is 84% investment grade
  • Coverage is over 104%
  • UNII was over 10 cents as of June
  • Liquidity is moderate at 26K shares per day
  • Leverage stands at 38.5%
  • And most importantly, the call schedule is benign for the next couple of years

Wrapping It All Up – The Keys!

While it is safe to say most investors are picking and choosing investments based on the merits and process they use, many are failing to incorporate a process on the portfolio construction itself. That is as important (if not more) than the security selection. Creating a portfolio by piecing together a bunch of REITs and other dividend paying stocks without an eye toward risk can be dangerous – as many found out in March.

Risk control should be the primary function of the portfolio construction process. The member’s portfolio above is a prime example of that. While he is down slightly for the year, the portfolio throws off a massive amount of cash flow and has a portfolio beta of just 0.45. That helps dampen overall volatility while creating that cash machine. The security selection in the portfolio is mostly lower risk options for that category.

Investors could use that as a guidepost when creating their own cash machines. But do so with an eye from the top down. Remember, portfolio construction is not easy today. That was the point of my prior article. And it is only getting more difficult. Keeping tabs on risk and why each security is in the portfolio with the specific role it plays is extremely important.

Our Yield Hunting marketplace service is currently offering, for a limited time only, free trials and 20% off the introductory rate.

Our member community is fairly unique focused primarily on constructing portfolios geared towards income. The Core Income Portfolio currently yields over 8% comprised of closed-end funds. If you are interested in learning about closed-end funds and want guidance on generating income, check out our service today. We also have expert guidance on individual preferred stocks, ETFs, and mutual funds.

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Disclosure: I am/we are long ETO, BCV, GCV. 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.

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