It’s no secret that getting meaningful income in a portfolio is a real challenge these days. Add low-risk to the equation, and all you get is a laugh. The comic aspect aside, however, it is a real dilemma for those who have depended upon their retirement plans to generate income, only to learn that the only truly safe investment is government bonds, which pay the paltry rate of 1.8%. Even with lackluster GDP of 1.7%, real inflation is in excess of 2%, so you don’t have to be a math wizard to realize the numbers don’t work. And with the government’s latest round of easing, known in the vernacular as QE3, the outlook for higher rates on savings is bleak, as the Fed plans to purchase more bonds to flood the market with liquidity while keeping rates down to spur the tepid economy.
There are some options available, but not without some element of risk. It is important to understand just how much uncertainty you can tolerate. The “sleep at night” rule applies here in spades. If you cannot stomach seeing your securities statement ebb and flow, then cash is your choice. But be aware that by earning less than 1% in the bank while inflation hovers at 2% (some say even higher—at least those who drive and must factor in the high cost of oil these days), you are not ahead of the game. In time, the value of your cash’s purchasing power will erode. But, for the time being, you may sleep better.
Ratcheting up the risk scale a bit more presents a few options. Dividend-paying stocks is one. A few good companies are paying from 3.5% to 4%, so after inflation, you could net 2%. Taxes are a different issue, however. While the Bush tax accounts still are in effect, dividend income is taxed at 15%. That could change come January, depending upon the election outcome. In fact, there has been commentary in the press about companies, recognizing this pending change, that are opting to pay dividends in calendar 2012 to enable their shareholders to capitalize on the lower tax rates.
Dividend-paying stocks are attractive because if the share price increases in value (as most stock investors hope), then that dividend enhances the return. For example, assume you purchase a stock at $50 that has a 3.5% dividend. If the stock doesn’t move at all, at the end of the year you have $51.75. If, however, the price moves up 10%, to $55, your total return is $5 plus $1.75, or $6.75, a return of 13.5%. But, don’t forget that the market can just as easily fall 10%, and your $50 just as easily can become $45. But either way, you still have the $1.75 in dividend income, and if no one is standing with a gun to your back forcing you to sell, you can hold the stock in hopes of its recovering or even moving higher. Shares of companies with solid earnings and that pay dependable, increasing dividends, tend to experience less price fluctuation than do stocks without these characteristics. Over time, dividend-paying stocks experience a steady rise in value, and generally recover faster during a market downturn.
Then there are enhanced dividend strategies that rely on a combination of high-quality dividend-paying stocks plus an options overlay to boost the return. Craven Capital, a newly formed registered investment advisor in New York, offers a hedged equity income portfolio offering both yield and downside protection through careful use of options. According to founder Brian Macnish, “Investors are looking for yield, yet they are risk averse in the wake of the 2008 collapse and the current market climate. Traditional fixed income strategies do not meet their objectives and are relatively risky from a purchasing-power perspective with inflation where it is today. We offer investors current income, capital appreciation and downside protection–for a reasonable management fee”. The company’s goal is to achieve an 8%-10% total return, from a combination of the dividend plus the enhancement of the option premium income feature, which Craven has managed to do since its inception earlier this year.
There are also exchange-traded funds (ETFs) that focus on dividends. Ishares is one such company that offers these kinds of investments. Two examples are the Dow Jones International Select Dividend Fund (IDV) and the Dow Jones Select Dividend Index Fund (DVY). ETFs are attractive because the fees are low and they are fairly tax efficient. The usual argument against ETFs, that an investor will not enjoy any alpha, or excess return, really does not apply with dividend ETFs, because a money manager with a dividend strategy is not attempting to produce alpha.
On the fixed-income side of the investment ledger, there are strategies designed to perk up your portfolio’s performance. Emerging markets debt funds are an example. While it takes a strong stomach to buy the bonds of Spain and Greece these days (and you certainly may be rewarded handsomely for doing so), those with a tad less appetite for risk can explore other countries’ debt. One company, Stone Harbor Emerging Markets Debt Fund (ticker symbol EDF) has returned 9.74% since November 2011. Its heaviest weights are in Russia and Mexico, followed by Argentina and Brazil. Through a combination of macroeconomic analysis (in English, that means examining world markets, including the political situation, growth, trade, interest rates and prices of countries around the globe), and credit research for both countries and industries within them, Stone Harbor determines which countries represent the best opportunities, and then buys the debt of those countries. It is a closed-end fund, meaning its shares trade like a stock. But, and here’s the catch, it has been around for just a year. It may be the next best thing, or it could struggle in the future. With a short track record, there is no way to measure how it has performed during adverse times, such as a global meltdown, although a case can be made that the Eurozone is in its own kind of meltdown, and Stone Harbor wisely has eschewed it. However, in contrast with the above-noted dividend paying stocks, companies that pay dividends generally have been around for a long time and thus have a lengthy track record.
Not for the faint of heart are another vehicle, structured notes, one of the many derivatives in the market place. First, a derivative, eponymously named, “derives” its value from an underlying security (hence the term “derivative”), and in the 2008 market crisis, we all were forced to learn more about them than we might have wished. Derivatives have all kinds of permutations with varying degrees of risk associated with each. Structured notes combine the benefits of the stock market with a level of perceived protection against the downside. Wall Street has been marketing them in droves, a bit of a red flag in and of itself. When it’s that popular, you can bet it’s good for the salesman, perhaps not quite so much for you. That said, here is how they work: you purchase a security and give up some of the upside in exchange for protection that it will not drop below a pre-set amount. For example, suppose you buy a stock at $50 that you hope will appreciate 20%, to a future market price of $60. Suppose, however, that it appreciates to $70. In this example, your arrangement is to forego any profit over your contracted $60 (in this case, $10), in exchange for a “floor” below which you are protected. How much protection you want is factored into the price of your contract (hence, the term “structured”). If you do not want to lose more than $5 (in this example, your stock drops to $45), you will pay a higher fee than if you can stand losing more, say $10 (your stock drops to $40). Also, the contract is for a specified time, and you must hold the position until maturity or forfeit the downside protection. This matters a lot if the market tanks during your holding period, and you have to swallow the excess volatility.
In addition, it’s a good idea to understand the creditworthiness of the issuer. Lots of folks purchased derivatives from Lehman Brothers–remember them? They are no more. Nor will your investment be, because you are an unsecured creditor should the issuer fail. Finally, these products are expensive to purchase, with commissions running to 3%. They may have a place in your portfolio, but like anything else, do your research and be sure you understand what you’re getting. As one friend of mine comments, “I’d rather know what I’m buying and own the real deal, rather than a Wall Street sausage”. That’s a pretty good definition of a derivative. Remember that in 2008, lots of people thought they were buying triple-A rated securities in the mortgage industry. When the fog was cleared away, they were holding stuff that no one wanted to buy, and their portfolios plummeted. For more information on derivatives in general, see a piece that appeared in June 2012 on the Forbes.com site. It is “must” reading for investors contemplating an investment in derivatives. Structured notes are arranged and purchased through a brokerage firm.
To summarize, understand yourself and how much you can afford to lose (Rule #1 in Investments 101) and then do your research. If delving into the numbers is not your thing, make sure your trusted advisor does it for you. Be wary of promised high returns. A lengthy track record gives you more information, but it does not predict future results.
This article is not meant to be investment advice. As in any investment strategy, you should consult your advisor before making any decision.