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The Risks of Yield Seeking Strategies
Over the past couple of weeks I’ve focused on high-yield corporate bonds, but three other yield-oriented investments I frequently get asked about are high-dividend stocks, preferred stocks and oil-and-gas master limited partnerships (MLPs). In the past couple of years, I’ve found that most investors who ask about these strategies are contemplating using them in place of high-quality fixed income because “fixed income rates are low.”
 
The most important message that investors need to understand — not that this is necessarily good news, but it’s the truth — is that there’s no solution to the low-rate problem that doesn’t involve an increase in risk (volatility, tracking error risk or otherwise). We all currently live in a world where near-term expected returns on safe investments are below the rate of expected inflation. There’s nothing any of us can do to change this economic reality.
 
I want to be clear though: I’m not saying that investors shouldn’t contemplate portfolio changes if it’s unlikely they’ll be able to achieve their financial goals or they could potentially improve portfolio diversification. However, they should understand that these changes will likely subject them to more risk and most portfolio changes won’t have a major impact on the likelihood of achieving your financial goals once the additional risk is accounted for relative to other choices like saving more and spending less in retirement.
 
When looking at high-dividend stocks, preferred stocks and oil-and-gas MLPs, it’s clear that all of these strategies involve substantial risk. The first table reports the total returns of each strategy during the worst quarters for the stock market in recent times:
 
 
The table shows what I would generally expect. These strategies typically don’t do well when the market is doing poorly. That shouldn’t be a big surprise since each strategy either has direct exposure to the stock market or contains “stock-like” risks.
 
The next table reports the difference in returns over these same periods for the above strategies relative to U.S. Treasury bonds. A negative number represents underperformance of these strategies relative to U.S. Treasury bonds.
 
 
What this table shows is that these strategies tend to dramatically underperform safe fixed income when market risks show up and points out the risk of replacing high-quality fixed income with higher yielding strategies.
 
Random Links and Commentary of the Week
 
The Economist had a recent article on the relationship between age at the time baseball players are drafted and future performance in the majors.
 
Good to see that UBS has its finger on the pulse of the marketplace. I’ve been looking for a strategy that promises to give me twice the return of the Russell 1000 Growth Index, and I’m sure others have been too.
 
Jared Kizer is the director of investment strategy for BAM Advisor Services. See our disclosures page for more information.

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