A lot of people are stuck in their traditional stock and bond asset split, but with exchange traded fund products, investors can diversify and expand on traditional allocations to augment their current income. Low-volatility and dividend ETFs are attractive options for yield.
In a recent webcast, Morninstar analyst Samuel Lee pointed out that there are valuation-conscious ways to generate more income in an income-tilted investment portfolio.
First off, Lee explained that “investors often focused on headline yield rather than real yield.” Consequently, when determining real yield, investors have to account for options costs – the call options that allow issuers to redeem bonds in case interest rates fall, default rates and inflation.
Lee also highlighted the fact that most investors don’t make the distinction between yields and performance.
“In bonds, higher-yields usually mean lower risk-adjusted returns,” Lee said. “In high yield bonds, lower yield has produced higher total returns.”
The same can be said about the equities market.
“Extremely high-yielding equities (top 10%) have historically underperformed lower-yielding equities (top 20%-50%) and with higher volatility,” Lee added.
Consequently, Lee suggests investors should begin looking at low-volatility equity options in both the U.S. and foreign markets.
“Low-vol stocks have performed about as well as market, but with one-third less volatility over since 1930s,” Lee said. “Low-vol stocks tend to have above-average dividends.”
“I think U.S. equities are overvalued, trading among the highest price-to-earnings value out there,” he added.
Lee provided a standard portfolio model with 30% in Vanguard Total Stock Market ETF (NYSEArca: VTI), 30% in VanguardFTSE All-World ex-US ETF (NYSEArca: VEU) and 40% in Vanguard Total Bond Market ETF (NYSEArca: BND). All in all, the portfolio comes with a real yield of 1.35% and an average expense of 0.11%.
Investors can make more valuation-conscious tilt toward income by including low-volatility and dividend Europe and emerging market equities and lowering exposure to Treasuries. For instance, Lee suggests an income-tilted portfolio with Vanguard Total Stock Market ETF (NYSEArca: VTI) 15%, PowerShares &P 500 Low Volatility (NYSEArca: SPLV) 10%, VanguardFTSE All-World ex-US ETF (NYSEArca: VEU) 15%, iShares MSCI EAFE Min Volatility (NYSEArca: EFAV) 10%, WisdomTree EM Equity Income (NYSEArca: DEM) 10%, iShares MSCI EM Min Volatility (NYSEArca: EEMV) 10% and PIMCO Total Return ETF (NYSEArca: BOND) 30%. The portfolio comes with an average 2.47% yield and a 0.33% expense.
If you crave added yield, Lee suggests adding the PIMCO 0-5 Year High Yield Corporate Bond Index (NYSEArca: HYS) as it holds short-duration and higher quality speculative grade, or “junk” bonds.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.