The chase for a yield can quickly spin a portfolio out of control.
Retirement planning has always been a complex and challenging process. There’s no real way around that; it involves estimating how multiple impossible-to-predict variables will play out over a lengthy period of time. But rules of thumb and a generally cautious approach have historically been a pretty good combination.
Some additional challenges are facing those now planning for retirement. Firstly, the distribution of life expectancies continues to to increase. Many of those currently in their 50s will live well into their 100s. Those in their 20s and 30s may ultimately spend more than 50 years in retirement.
Secondly, the general expectation is that most asset classes won’t match the impressive gains delivered for the last 30 years. Between 1965 and 2014 the S&P 500 increased at an average annual rate of 9.8 percent; some expect gains of less than 2 percent annually over the next decade.
A high-yield portfolio may begin to appeal as a solution to such uncertainty. The benefit here is relatively straightforward; if retirees can use only dividends from their portfolio to cover living expenses, a prolonged life span or low returns on stocks and bonds won’t be causes for concern.
But, alas, this too will prove to be an unrealistic goal for most. To understand why high-yield portfolios aren’t a silver bullet, we can examine two general strategies for constructing a high-yield portfolio (with specific examples to go with each).
Upgrade the Core
The first strategy for creating a high-yield portfolio involves swapping out core holdings for similar funds that offer similar exposure but a slightly higher yield. Consider a very simple 60/40 portfolio consisting of three Vanguard funds and yielding about 2.3 percent:
The Vanguard High Dividend Yield Fund (VHDYX) has considerable overlap with VTSAX, but is tilted a bit more toward higher yielding U.S. stocks. Swapping these two funds results in a decent yield increase for the total portfolio:
This “upgraded” portfolio has a weighted average expense ratio of 0.13 percent, approximately four basis points more than the portfolio based around VTSAX.
Sprinkling in Risk (And Yield)
There is another approach to increasing the yield on a portfolio: including exposure to less traditional asset classes that are characterized by more substantial distributions. Specifically, an investor could drop in real estate, MLPs, or junk bonds. As shown below, it doesn’t take huge weightings to move the needle on the portfolio’s overall yield.
It’s important to keep in mind that additional yield often goes hand-in-hand with additional risk. These additions to the portfolio introduce new and significant risk factors; all of these asset classes are capable of big declines in value. So limiting the allocation to single digits is key.
What Not to Do
If you’re looking to build a high-yield portfolio, there are some tempting shortcuts. But these come with the potential drawback of loading on too much risk or too many fees. Below are a couple of strategies for a high-yield portfolio that won’t make sense for most investors.
Loading Up On Risk
Remember that high yields exist to compensate investors for taking on risk. If an asset class features an attractive yield, it probably comes with numerous risk factors. These may be generic risks (e.g., potential for big losses in down markets) or specific factors such as sensitivity to rising interest rates or currency fluctuations.
Below is an example of a portfolio that will deliver a very attractive yield but that is just asking for trouble:
That 5.2 percent yield might have your mouth watering. But that drool will give way to tears if interest rates jump, corporate defaults rise, oil stays cheap, or the economy struggles. There’s an incredible amount of risk in this hypothetical portfolio; several of these components have demonstrated their ability to drop half of their value (or more) in a short period of time.
Paying for Yield
Another temptation will be to crank up the yield in the core holdings with actively-managed funds that explicitly seek high-yield stocks. While the payouts on these funds will catch your eye, there are two potential drawbacks: 1) they’re likely to be quite risky (see above); and 2) they’re likely to be quite expensive.
The following table highlights some of these tempting funds:
Using any of these funds in place of VTSAX in our example above would certainly increase the yield on a portfolio. But that higher yield would come with a significant increase in fees too. It’s hard to justify an expense ratio of more than 1 percent in any scenario; such a hefty price tag at the core of your portfolio creates a major headwind.
The Tough Reality
For many investors, an ideal retirement involves living off of dividends collected from a low-risk portfolio. But there are some substantial obstacles to that dream in the current environment. Interest rates and dividend yields are well below their historical averages. As a result, most retirement portfolio allocations will yield 2 percent or less.
There are plenty of tweaks that can push up current income, but any meaningful increases will require taking on a substantial (and generally inappropriate) amount of risk. A yield much higher than 3 percent is mutually exclusive with a risk profile that is appropriate for retirees.
There are two important takeaways here. Firstly, to state the obvious conclusion, living off of dividends requires a pretty substantial portfolio. Generating $60,000 annually will likely require a portfolio between $2 million and $3 million.
Secondly, minimizing fees is extremely important. For too many investors, the combination of expense ratios and management fees will exceed the yield on their portfolios. The idea that low costs are important is nothing new, but the comparison to available yields illustrates the pain of paying too much.
About the Author: Michael Johnston
Michael Johnston is senior analyst for Fund Reference, and also serves as COO of parent company Poseidon Financial. His investment expertise has been featured in The Wall Street Journal, Barron’s, and USA Today, among other publications. He resides in Chicago.