The Ultimate Income Portfolio, which was published in this newsletter July 6 of last year, has delivered the risk-adjusted returns that I projected. Here’s a detailed look at how last year’s portfolio performed and several ways it can be improved in today’s environment.

The thesis of the original article was that it was possible to build a portfolio with almost a 10% annual yield at a risk level that many investors would deem acceptable.  My approach to creating an income-oriented portfolio was unusual and got considerable attention, thanks in part to a discussion by well-known columnist and advisor Scott Burns. 

My proposition is that the best way to build an income portfolio is to optimize yield versus risk.  Yield is directly observable.  Risk is not as easy to see, but it is observable too.  We can estimate the risk associated with any investment by looking at the costs of options on that investment.  With the emergence of options on exchange-traded funds (ETFs), we can measure the risks of entire asset classes very easily in this way.

This approach to building an income portfolio is compelling, because it is hard to argue with the meaningfulness of either option-implied risk or yield.  Alternatively, one could construct a portfolio based on expected total return, but that requires assumptions about the future equity-risk premium.  Using stocks with consistent histories of paying dividends makes the forecast for future dividends quite straightforward.  Realized volatility is reliably predicted by implied volatility.  To frame this in a different way, there is considerably more estimation error in expected total return than in either yield or risk. 

My 2010 article started by treating all sources of yield on an equal footing.  Yield is any payment to the holder of the portfolio.  We can get yield from bonds, stock dividends, MLPs, REITs or sales of covered calls.  My goal in constructing the ultimate income portfolio is to identify a portfolio that provides the highest total yield at a target level of risk for the holdings in the portfolio.  I determine the aggregate portfolio risk by starting with the estimated risk of each portfolio component that is consistent with options prices and then accounting for the correlations between individual investments. 

The original ultimate income portfolio had a projected total yield of 9.7%, with a total expected risk level of 21% in annualized volatility — very close to that of TLT, iShares’ long-term government bond ETF, which has implied volatility of 21% and was yielding only 3.9% at the time.

Over the last year, I have continued to explore this approach, and its appeal is undiminished.  At the one-year anniversary of the original Ultimate Income Portfolio, I review the performance of the portfolio over the past year and explore the improvements that my ongoing research suggests. 

The original portfolio

In my original analysis, I used data available through June 30, 2010.  We will start by examining the performance of the original Ultimate Income Portfolio from June 30, 2010 through July 21, 2011 (the date of this writing). 

The original portfolio was equally weighted among 10 elements: nine individual stocks and one high-yield bond fund.  In my original analysis, I explored whether an allocation to nominal bonds could add yield at the target risk level, but I projected that nominal bonds would not improve the portfolio.