The Ultimate Income Portfolio Revisited
Rising interest rates will be unkind to income-generating assets and the investors who depend on them in retirement. My ultimate-income portfolio (UIP) provides a solution to this problem. It has reliably produced high income and low volatility with respect to the stock market, and its performance is likely to continue, even if rates rise further.
In July 2010, I introduced a novel approach to building an income portfolio. My goal was to construct a portfolio with the maximum level of income at any individual investor’s appropriate risk level. In each of the following two years, I examined its performance and modified the portfolio for the next year. This article, the fourth in this series, starts with a brief summary of the approach, followed by an analysis of its performance over the past year, and concludes with a new iteration of the portfolio for the coming year and a summary of lessons learned so far.
In my approach to constructing the UIP, summarized here, I start with analyzing the universe of income-producing assets to determine the portfolios with the highest yield for a given level of risk (defined as volatility). This creates an efficient frontier of yield versus risk and incorporates the value of diversifying across asset classes. I then analyze the value of selling call options against taking positions for which options are actively traded. Because there no options are traded on mutual funds, the portfolios are made up of stocks, exchange-traded funds (ETFs), real-estate investment trusts (REITs) and master-limited partnerships (MLPs).
This approach focuses on elements of portfolio design that are directly observable and stable over time. Yield is observable and persistent. Risk is also directly observable when options are traded on an asset. Implied volatility, based on the prices of options, is the market’s consensus estimate for future risk. The income that is derived from selling covered calls is also directly measurable. By contrast, total return is not stable over time, and estimates of total return are more uncertain than estimates of income. No matter how good our models are, the expected total return from a portfolio is not directly observable, because the equity risk premium is not observable.
Observable measures are superior to unobservable ones because they lower the risk of estimating future returns. As I have discussed, income investing is attractive because estimates of future income are more accurate than those of total returns.
Lower estimation risk does not reduce other sources of portfolio risk, nor does my strategy imply that an income portfolio will outperform over any timeframe. We would not have expected that an income strategy would shine on a total return basis during 2013, when the S&P 500 increased 16% on a price basis. Nor has it. On the other hand, as I will explain in the next section, my UIP provided the projected level of income and volatility.
Review of last year’s portfolio
Last year’s portfolio, published on Sept. 4, 2012, was primarily allocated to high-yield bonds (20%), telecom stocks (18%), MLPs (23%), Treasury bonds (15%) and utilities (12%). Two additional holdings were an 8% allocation to a closed-end fund (EOD) and a 4% allocation to Astrazeneca, a major pharmaceutical company.
Ultimate Income Portfolio in at the start of September of 2012