The Ultimate Income Strategy - Higher Yield and Lower Volatility

Investors, especially those in the de-accumulation phase of their retirement, count on high income and low volatility.  Achieving the best possible tradeoff between yield and risk is a major challenge for advisors.  Over the last two years, I’ve shown how to construct a low-risk portfolio – the ultimate income portfolio (UIP) – that yields over 9.0%.  Let’s look back at how those portfolios performed and the components of this year’s UIP.

My original motivation for creating the UIP in 2010 was to find a way to consistently compare the yields on a wide range of potential investments to their respective risk levels (volatilities) and, in so doing, to help investors to make optimal trade-offs to achieve the highest portfolio yield for any given level of risk.  The results of my analysis showed that it was possible to generate a high level of income with moderate risk.  After one year, my original UIP performed exactly as projected, generating 9.7% in income.

Over the last two years, yields on Treasury bonds have dropped to unprecedented lows and the yields of other fixed-income instruments have fallen in tandem.  Because of a substantial rally, yields on equities are also substantially lower. Given those challenges, it is now more crucial than ever for income-oriented investors to apply a robust and objective approach to building income portfolios. 

Let’s review the core concepts behind the UIP and my methodology for constructing each year’s new iteration of it. I’ll discuss how the 2010 and 2011 UIPs have performed relative to expectations, and reveal the components of this year’s UIP.

The methodology behind the UIP

The UIP is based on the following foundations:

  1. Yield is observable;
  2. Risk is measurable (by observing historical volatility and option-implied volatility);
  3. Options on ETFs provide a standardized and consistent risk measure; and
  4. Covered calls sold against income-generating assets provide incremental income.

Let’s look at how these precepts allow us to construct a portfolio that combines high levels of income with low risk.

This emphasis on investment characteristics that are directly observable (yield) and measurable (risk) contrasts with other portfolio construction methodologies, which usually rely on assumptions about the future returns from equities.  Those projected returns hinge on an equity-risk premium that is neither observable nor directly measurable. Any estimate of the equity-risk premium is based on our beliefs and is therefore subject to a significant uncertainty, in the form of what’s known as “estimation risk.” By focusing on observable and measurable characteristics, I reduce that estimation risk.

The maturing market for options on ETFs provides a transparent and consistent measure of risks across all major asset classes.  The prices of options are largely determined by the expected risk in the underlying security.  Financial data sites have calculators that use options prices to back out the level of risk (volatility) implied by options prices.  Implied volatility is a key variable in asset allocation decisions, because it is the market’s consensus estimate of risk in any given asset class. 

I have performed extensive benchmarking of the Monte Carlo portfolio simulation tool that I developed (Quantext Portfolio Planner) to ensure that the model’s projections for portfolio risk are reasonable, based on its use of implied volatilities.  (For more on this, see Appendix A of this article, which shows how closely projected risk for the components of the updated UIP compare to implied volatilities of the options used to construct it.)

Selling call options against the holdings of a portfolio provides a low-risk way to generate additional income.  By selling calls, you are giving up possible gains if the market rallies.  For an income investor, however, price appreciation is a secondary concern.  Further, you can select the strike prices of the call options that you sell to retain more or less of the upside potential.  Choosing call options with higher strike prices allows you more potential to gain, but it also reduces the amount of income you get from selling the options.