Retirement: How To Earn High Income Without The High Risk

Generally, a vast majority of folks, especially retirees, associate the Closed-End Funds [CEFs] with high risk, high leverage, and high fees. Many consider them unsafe and unsuitable for long-term holdings. Some others would argue that they have no place in a conservative or a retirement portfolio. Though it is easy to understand why, we tend to have a different opinion. There is no doubt that at times, their market prices can be volatile, more than the broader market-indexes or dividend stocks. It is also difficult to separate the good funds from the bad ones. We believe that in spite of their obvious risks if used with the appropriate diversification and right proportions, they can provide high-income, moderate risk in line with the broader market and at the same time provide market-matching or market-beating returns. It is not about all in or nothing; it is about the right proportions. How much is appropriate? The right amount of exposure to a specific type of investment usually depends on several factors including an individual’s goals, risk tolerance, and personal situation.

We will go over both the benefits and the risks of investing in this kind of portfolio strategy. However, we believe that there are more positives than the downsides and that’s why it deserves a place in your overall strategy. At the same time, they are not for everyone. First, if your investment pool is large and your income needs are less than 3-4% of your investment pool, there may not be a need at all to go for a higher income portfolio. Second, if you cannot tolerate slightly higher volatility (than S&P500), even while you are receiving the high income, you should probably stay away. Lastly, if you do not care about income, but just the total return, obviously these investments are not for you.

We will run several back-testing examples to provide the readers a glimpse of benefits versus risks in comparison to the broader market indexes. In fact, if used in the right proportions in terms of allocation, a CEF portfolio may provide higher income, lower risk, and the longevity of an income-focused portfolio.

In the end, we will provide some updates on our 4-year-old model portfolio, “The 8% Income CEF Portfolio”, which we have maintained here on SA and provided regular updates/reviews. Incidentally, this portfolio is also part of our Marketplace HIDIY service.

Back-Test # 1: (10-CEF Portfolio – Investment over 10 years)

CEFs selection and strategy:

We selected 10 CEFs that were introduced in 1994 or earlier. Selecting CEFs with such a long history is a tough call since a lot of popular CEFs today did not exist prior to 2004 or 2005. Another important criterion for CEFs selection was that we wanted each CEF to belong to a different asset class, and would avoid duplicity as much as possible.

By selecting 1995 as the beginning year, we would be making purchases at increasingly higher prices, especially in 1997-1999. But the subsequent bear market from 2001 to 2003 would even out our cost basis. By selecting the period from 1995 to 2017, we are able to include two full-blown bear markets and two bull-market periods.

We fully understand and appreciate the fact that this process would introduce some element of selection bias. The first factor is that a fund with such a long history would (more than likely) be a successful one. But that may not be entirely true, as there would be others with mediocre performance. However, a selection strategy of picking the best fund among its respective asset class can avoid the pitfalls. Secondly, there may be the beginning year bias. To remove the beginning-year bias, we have included an additional back-testing model (please see the model#3), which should help remove any doubts on that front.

Here is the list of 10-CEFs that we selected going back to 1994-1995:

CEF Name

Symbol

Asset-type

1

John Hancock Financial Opportunities Fund

(BTO)

Equity Securities – U.S. Banks, Regional Banks, Thrifts/Finance holding cos.

2

Tekla Healthcare Investors

(HQH)

Healthcare and Medical Technology

3

Alliance World Dollar Government Fund I

(AWF)

High Yield Government and Corporate Fixed Income Securities

4

Cohen & Steers Total Return Realty Fund

(RFI)

Real-Estate – Equities and Debt Securities

5

PIMCO Commercial Mortgage Securities

(PCM)

Mortgage-backed Securities, Non-Investment Grade Securities

6

New America High Income Fund

(HYB)

Corp High Yield Bonds

7

Morgan Stanley Emerging Markets Fund

(MSF)

Emerging markets Equity Securities

8

Liberty All-Star Equity Fund

(USA)

Equity Securities – US Companies

9

John Hancock Premium Dividend Fund

(PDT)

Preferred Stocks and Dividend Equity Securities

10

Blackrock Muni-Yield Fund

(MYD)

Municipal Bonds – Investment Grade (Tax Exempt)

## Blackrock Muni-Yield Fund (NYSE: MYD) is a Tax-Free Municipal Fund. It may not be suitable inside a 401(k) or IRA account. However, one can choose a taxable municipal fund.

Assumptions:

  • We invested $10,000 every year from 1995 to 2004 (first trading day, every January). Over 10 years, total original investment amounted to $100,000.
  • We would withdraw 6% income from this portfolio (on a yearly basis at the year-end) on the invested capital and take an increase of 2.5% per year for inflation adjustment.
  • Income withdrawals would start right from the first year.
  • The begin- date for the back-test is January 1st, 1995. End-date is December 31st, 2017.

10-CEF Portfolio Return & Income Calculations: – 6% (with inflation) Income Withdrawn:

S&P 500 Return & Income Calculations:– 6% (with inflation) Income Withdrawn:

Performance comparison of the 10-CEF portfolio with S&P 500:

10-CEF Portfolio

(From 1995-2017)

**S&P500

(From 1995-2017)

Total Original Investment

(Contributions made for first 10 years)

$100,000

$100,000

Total Income Withdrawn

$130,011

$130,011

Net Portfolio Value (after income)

$230,801

$116,721

Compounded Annualized Return (in addition to income)

4.76%

0.86%

Net Portfolio Value (No income withdrawn)

$592,483

$432,383

Compounded Annualized Return (when no income is withdrawn)

10.39%

8.47%

*Annualized returns were calculated on the basis of 18 years (not 23 years) since investments were made over 10 years.

**Performance of S&P500 has been taken from the Vanguard 500 Index Fund.

As you could see, for nearly 24 years, the 10-CEF portfolio has performed very well. It provided inflation adjusted 6% income every year and still provided nearly 5% compounded return in terms of capital appreciation. However, if you had put the same amount in S&P 500, after taking inflation-adjusted 6% income every year, S&P 500 did not perform nearly as well and ended up providing very little appreciation (0.86%) in the capital.

Back-Test # 2: (10-CEF Portfolio – Investment over 20 years)

Assumptions:

  • We invested $10,000 every year for 20 years from 1995 to 2014 (first trading day, every January). Over 10 years, total original investment amounted to $200,000.
  • We would withdraw 6% income from this portfolio (on a yearly basis at the year-end) on the invested capital and take an increase of 2.5% per year for inflation adjustment.
  • Income withdrawals would start right from the first year.
  • The begin-date for the back-test is January 1st, 1995. End-date is December 31st, 2017.

Performance of CEF Portfolio – 6% (with inflation) Income Withdrawn:

Performance of S&P500 – 6% (with inflation) Income Withdrawn:

Performance comparison of the 10-CEF portfolio (contributions for 20 years) with S&P 500:

10-CEF Portfolio

(From 1995-2017)

**S&P500

(From 1995-2017)

Total Original Investment

(Contributions made for first 20 years)

$200,000

$200,000

Total Income Withdrawn

$210,084

$210,084

Net Portfolio Value (after income)

$381,290

$252,115

Compounded Annualized Return (in addition to income)

5.09%

1.80%

Net Portfolio Value (when no income withdrawn)

$848,773

$682,218

Compounded Annualized Return (when no income is withdrawn)

11.76%

9.90%

*Annualized returns were calculated on the basis of 13 years (not 23 years) since investments were made over 20 years.

**Performance of S&P500 has been taken from the Vanguard 500 Index Fund.

As you can see, when we do not draw any income, CEF Portfolio performs better than S&P500 leaving a larger balance in the end. However, performance improvement becomes more prominent and significant when we are drawing a constant 6% income (with annual 2.5% increments for inflation).

Back-Test # 3: (10-CEF Portfolio – Multiple Beginning Years)

We wanted to remove the beginning-year bias if there was any, so we decided to include another back-testing model. We would perform the same test (Back-test#1) for our 10-CEF portfolio and S&P 500 with commencement year to move by a year each time (from 1995-2016).

Assumptions:

  • We invested $10,000 every year for 10 years from 1995 to 2014 (first trading day, every January). Over 10 years, total original investment amounted to $100,000.
  • We would withdraw 6% income from this portfolio (on a yearly basis at the year-end) on the invested capital and take an increase of 2.5% per year for inflation adjustment.
  • Income withdrawals would start right from the first year.
  • We conduct a series of tests, each time we change the commencement date. We start with 1995, then with 1996, 1997, 1998 and so on until the year 2016.
  • For each back-test series, the End-date is December 31st, 2017.

Here are the results, in a graphical form. The results favored the 10-CEF portfolio strongly until the year 2008. Only after the year 2009, S&P 500 started outperforming the 10-CEF portfolio slightly.

Note: In the graph, starting years from 2009 to 2016, the investment was less than 100,000 (10K per year). However, they were normalized to a base of 100,000.

Up until the year 2008-2009, the 10-CEF portfolio beat S&P 500 almost every time, irrespective of the year you may have started this portfolio. After 2009, however, both have performed more or less even, but S&P500 has taken a small but clear lead due to the very strong bull market of the last 10 years. The chart also shows that if you were a buy-and-hold income investor, investing in the S&P 500 index during 1995-2001 was not such a good idea.

Backtesting Summary/Remarks:

Even with these three extensive back-testing models, we do agree that some element of selection bias could remain as to the kind of CEFs we picked. One possibility could be that since we were looking for CEFs that had 25+ years of history, a majority of them probably had a better-than-average track record, and the ones with bad track records did not survive for this long, so never made to our list.

In our view, the success of 10-CEF portfolio boils down to the following factors:

  • Wide diversification among varied asset classes; some of them have low correlation with the stocks.
  • Investment over long periods (in a staggered manner), in this case over 10 years. By doing so, even though we bought at the very peak prices during 1996-1999, but we also bought at the bottom during the recession of 2001-2003 at the bottom.
  • Selection of CEFs that have a good track record of maintaining their NAVs (Net Asset Values). We need to be careful to be selective about which CEFs we buy into. Not all are equal in terms of quality.
  • Selected CEFs should have yields in excess of 6-8% and possibly have positive UNII (Undistributed Net Investment Income). This may not apply to some categories of CEFs.

Risks to CEFs Investing:

Obviously, there are some risks to CEF investing, especially when the entire portfolio is based on CEFs. There are several well-known risks.

  • A vast majority of CEFs use high leverage, generally in the range of 20-35%. Some use even higher. This leverage helps them earn higher investment income which then supports a high level of distribution rates. However, leverage works both ways. It does wonders in good times, but during recessionary times it can really hurt their bottom lines.
  • CEFs are generally known for high fees. Normally a part of these fees covers the interest on the leverage being used. However, NAVs are reflected net of fees, and there are no separate fees that the investor has to pay.
  • CEFs provide high distributions, ranging from 6-10%. However, many times, the high distribution may consist of ROC (return of capital). The ROC is not always bad, but it is difficult to separate the good ROC from a bad one.
  • Their market prices normally differ from their NAVs, and this difference is known as discount or premium. To an investor, a discount is obviously better as you would be buying it less than what it is worth. But sometimes, a CEF may be trading at a large discount for a valid reason, for example, its UNII is consistently negative and is not sufficient to support the distribution and a distribution cut may be imminent. When a distribution cut happens, not only the income will reduce, but the market price will fall as well. Another reason could be its track record in terms of NAV has been less than desirable.

In our view, the track record of a fund matter, especially with regards to its NAV. Of course, the comparison should be made within the asset class that the CEF invests in. For example, we know that all energy-related CEFs had performed poorly during 2015-2017 energy prices bust, but still, there will be some who have performed better than others within their class. Also, when we talk about performance, it is better to compare NAV performance rather than the market price.

Our Current “8% Income CEF Portfolio”

We started this model portfolio in October of 2014, and since then, we have published several periodic updates on SA. At the outset, this portfolio had two simple goals; first, to provide 8% income (by way of dividends and distributions); and secondly, provide some capital appreciation over the long term. For income-seeking investors, 8% income will allow a withdrawal rate of up to 6% and leave 2% for growth.

Author’s Note: This model portfolio is part of our “High Income DIY Portfolios” SA Marketplace service. For more details, please see at the top of the article, just below our logo.

In this model portfolio, we allocated $100,000 initially, and another $100,000 was allocated in the next 12 months ($8,333 in 12 installments). Thus the total cost basis for the portfolio stands at $200,000 (excluding the reinvested dividends).

Cash added/contributed:

Initial Investment 10/17/2014:

$100,000

From Nov. 1st, 2014 until Oct 1st, 2015

$100,000

12 installments of $8333. 33

TOTAL Contribution (Cost basis)

$200,000

In this income-centric portfolio, we utilized a diversified group of CEFs. Initially, we selected 12 funds and added a few more in the subsequent years. This approach has provided us a broad diversification, high distributions, and exposure to different types of assets such as Equity, Bonds/Credit Securities, Utility, Infrastructure, Energy MLPs, Preferred Income, Floating-Rate Income, Healthcare, etc. Currently, we have three individual company stocks, one ETF, one ETN, and 11 CEFs.

Here is the current portfolio consisting of 16 securities:

Fund/Stock Name

SYMBOL

Fund’s composition

1

DNP Select Income (NYSE: DNP)

DNP

Utility (80%)

2

Kayne Anderson MLP (NYSE: KYN)

KYN

(MLP – Master Limited Partnership)

3

Guggenheim Strategic Opp Fund (NYSE: GOF)

GOF

Equity CEF fund

4

Columbia Seligman Premium Tech Growth (NYSE: STK)

STK

Equity CEF fund

5

Nuveen Muni High Inc Opp (NYSEMKT: NMZ)

NMZ

Muni Tax-Free ( Tax-free yield)

6

PIMCO Dynamic Credit Income (NYSE: PCI)

PCI

Global Income, including corporate debt, mortgage-related and other asset-backed securities

7

PIMCO DYNAMIC INCOME FD (NYSE: PDI)

PDI

Debt obligations and other income-producing securities

8

ISHARES US PREFERRED STOCK ** ETF **

(NYSEARCA: PFF)

PFF

Preferreds 90% (This is an ETF, not CEF)

9

COHEN & STEERS TOTAL RETURN REALITY Fund (NYSE: RFI)

RFI

REIT (Real Estate) CEF

10

COHEN & STEERS REIT & Preferred Income Fund (NYSE: RNP)

RNP

Preferred is 48%, 50% REIT

11

Cohen & Steers Infrastructure (NYSE: UTF)

UTF

Utility+Infrastructure (50% is International)

12

UBS ETRACS Monthly Pay 2xLeveraged ETN (NYSEARCA: CEFL)

CEFL

Exchange Traded Note (based on the index of CEFs)

13

Tekla Healthcare Investors ( HQH)

HQH

Healthcare/Biotechnology

14

Annaly Capital Management, Inc (NYSE: NLY)

NLY

mREIT

15

Main Street Capital Corp (NYSE: MAIN)

MAIN

BDC (Business Development Co)

16

Ares Capital Corp ( ARCC)

ARCC

BDC

Dividends:

Total dividends earned since portfolio inception: $59,263*

(*this includes $1,382 from securities already sold)

For the year 2018, the projected yield is in the range of $17,000, which will be 8.5% yield on cost.

1

Dividends collected until 09/17/2018

$59,263

3

Cost basis excluding dividends (09/17/2017)

$200,000

4

Portfolio balance (09/17/2018)

$269,843

5

Net profit/Loss (incl. dividends) (09/17/2018)

$69,843

6

Return on total contributed capital, including un-deployed funds

34.9%

Here is the portfolio as of 09/17/2018. The gains/losses shown below are without counting dividends, as they are not re-invested into original securities, but get deposited as cash.

Performance

The table below shows the funds in the portfolio in the order of performance (from best to worst) as of Sept. 17, 2018. The performance has been calculated and sorted after including the dividends.

Comparison with 60:40 Stock-Bond Portfolio:

Here is the performance comparison with a typical Stock-Bond portfolio.

Our Stock-Bond portfolio allocates in the ratio of 60:40 to stocks and bonds. The Stock/Bond portfolio mirrors the invested amounts with 8% CEF Portfolio (at different times). The hypothetical stock/bond portfolio has a 40/20/40 allocation to Vanguard Total Stock Market ETF (NYSEARCA: VTI), iShares MSCI EAFE – International (NYSEARCA: EFA), and (Vanguard Total Bond Market ETF (NASDAQ: BND). So far, the 8% Income Portfolio has beaten the Stock/Bond (60/40) portfolio on both total return and income for the majority of the time.

As of 09/17/2018

Total value

Dividends (since inception)

8% Income portfolio

$269,843

$57,187

60:40 Stock/Bond portfolio

$248506

$15,439

Closing Remarks:

We believe an all CEF portfolio presents a viable alternative to an all-stock or a balanced stock-bond portfolio, however, as part of a broader strategy and allocation model. Obviously, the primary benefit of this portfolio is the constant stream of cash income that it generates, and one does not need to sell shares to withdraw income. It appears that in good times (bull market), this portfolio, after including the dividends, should at least match the broader market performance. However, more importantly, during tougher times, the cash dividends would help protect the downside considerably, as is evident from back-testing models. The constant stream of income will also help the investor to resist the temptation to sell at the worst time.

With the help of several backtesting models and from the past four-year performance from our current model portfolio, in our opinion, we feel this 8% model will likely perform better than a broader market index fund, especially if we need to withdraw high levels of income on a consistent basis. So, we believe this portfolio would have a special appeal to income-seeking investors.

It is important to point out that this portfolio will not protect the investor from a broader market crash or correction. To avoid getting caught in a situation like 2008, we always recommend that one should invest gradually over a period of time, adding equal sums of money every time, which would hopefully smoothen the ride.

Disclaimer: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the author does not claim 100% accuracy. Any stock portfolio or strategy presented here is only for demonstration purposes.

Disclosure: I am/we are long ABT, ABBV, JNJ, PFE, NVS, NVO, CL, CLX, GIS, UL, NSRGY, PG, KHC, ADM, MO, PM, BUD, KO, PEP, D, DEA, DEO, ENB, MCD, WMT, WBA, CVS, LOW, CSCO, MSFT, INTC, T, VZ, VOD, CVX, XOM, VLO, ABB, ITW, MMM, HCP, HTA, O, OHI, VTR, NNN, STAG, WPC, MAIN, NLY, ARCC, DNP, GOF, PCI, PDI, PFF, RFI, RNP, STK, UTF, EVT, FFC, HQH, KYN, NMZ, NBB, JPS, JPC, JRI, TLT.

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.

Related Posts:

  • No Related Posts

Paul Rosen