In a recent post, I talked about how some income-seeking investors are using the strategy of investing in multiple asset classes in order to find yield.  As an example, I referred to the iShares Multi-Asset Income ETF (IYLD), which seeks to deliver yield and balance risk through diversified asset allocation.

In order to reach its goals, IYLD invests in some lower-yielding asset classes that may seem a little out of place for a fund that has the word “income” in the title.  For example, it has about a 15% allocation to the iShares 20+ Year Treasury Bond ETF (TLT) – currently yielding a rather unimpressive 2.8% [1].

Which begs the question: Why would a yield-oriented ETF invest in asset classes that aren’t yielding very much?   The answer, in a word, is diversification.  TLT’s role in the portfolio is not to add income, but rather to help decrease risk and to assist in providing relative stability to the fund’s performance.

Take a look at the chart below, which shows the hypothetical 5-year growth of $100 invested three different ways: the iShares 20+ Year Treasury Bond ETF (TLT), the iShares Select Dividend ETF (DVY – another one of IYLD’s holdings), and a hypothetical portfolio consisting of 50% in each (rebalanced monthly).

So what does this tell us?  First, you can see that TLT and DVY tend to move inversely, which is a good sign in terms of diversification.  When the assets in a portfolio don’t move in synch, the volatility of the portfolio is reduced.  This is why a diversified portfolio usually experiences less risk than the weighted average risk of its constituents – and often less risk than its least risky constituent.  Let’s see if that’s the case with this example:

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