We’re told 10,000 people a day for the next 20+ years will retire and need to live off of their investment portfolios. This oft-quoted statistic from a 2010 Pew Research report implies a massive, systemic change from accumulation to distributions. In an era of zero or even negative rates, financial innovators like Nasdaq are addressing this need by launching unique solutions to convert total return to regular monthly income.
People who no longer get a paycheck still need the timing of their cash flows to synchronize with the pace of their expenditures. As real interest rates draw near zero, investors must look to innovative approaches to fund the reality of their lives. Many seek opportunity in stocks and bonds to supplement traditional retirement sources. For some, distributions earned from securities, or pools of securities, are differentiated only by absolute yield. This has led to the creation of scores of multi-asset income approaches, difficult to compare, designed to produce increasingly higher distributions.
These strategies are not all the same, some approaches work well, others do not. Some schemes slice illiquid credit pools to deliver marginal yield increases that carry with them the potential for periods of nuclear-level meltdowns, while others pursue knife-catching strategies simply to generate big, fat, juicy, yet unsustainable yields.
The question investors need to answer is:
How do I earn a market return at a level of risk that is reasonable to me in order to receive a dependable stream of cash flows that aligns with my monthly expenses?
The 30-Day SEC Yield is considered to be the gold-standard for comparing yields, but the 30-Day SEC Yield doesn’t answer this question. It is blind to risk, ultimately guiding investors down the capital structure, based on an irrational inference that pass-through income should somehow be viewed independently of capital gains and losses.
Why should anybody have a preferred component of total return?
To help investors understand the pace of cash flows, marketers created new statistics using words like current, distribution and rate. These terms, have become ubiquitously known as “Income” and are acceptable only when shown alongside the 30-Day SEC Yield, but even distribution rates remain ignorant to risk.
By itself the 30-Day SEC Yield is perplexing because it gives investors no relevant information- nothing about risk, asset allocation, total return or even cash flow. The 30-day SEC Yield is simply the quantification of the pass-through element of total return. Why should anybody care that much about an accounting classification to make it the distinguishing unit of standardization?
Restricting the definition of yield to the pass-through of payments works only for instruments that have a defined term where, “at the end you get your money back.” This naive, but widely-held investor perception of risk translates to, “anticipate interim value fluctuation, but zero principal loss.” With this mindset, yield equals the average annual total return, except that isn’t how the real-world works.
A switch from a defined term (like a bond) to an un-defined term (like an equity or managed duration bond portfolio) means being subjugated to the indignities of volatility. In other words, the range of possible outcomes for any investment horizon will invariably produce higher highs and lower lows.
When comparing the 30-Day SEC Yield to the distribution rate of each of the components of HANDLS™ Indexes in the graph below, it is difficult to gain any insight other than MLPs seem to “earn their distribution”, whereas, apparently, covered call strategies do not.
From an investment perspective, did that make MLPs better or worse than covered call strategies?
Figure 1: When constructing a matrix for rational investment decisions, Total Return vs Risk seems more relevant than 30-Day SEC Yield vs distribution rate. HANDLS™ Indexes component constituent returns January 1, 2013 through April 15, 2020. Source: BAV, data Nasdaq Global Indexes
Investors Need Yield
Standard units of measurement are supposed to help consumers compare. When it comes to generating monthly income, the restrictive definition of yield serves the interest of the dominant market players and has ultimately hurt investors. The standardized definition’s embedded bias has guided investors to strategies that pass through large amounts of dividends and interest regardless of risk. A preferential tax treatment for dividends has made dividend dollars preferred to interest dollars and is the only rational explanation for anyone ever buying a list of the highest dividend payers. The move from interest dollars to dividend dollars shifts risk to investors, inflates relative valuations for big-dividend payers with low growth prospects, subjects investors to the risk of dividend cuts and ultimately exposes investors to greater volatility and substantially higher drawdowns.
How was any of this the objective of creating a unitized measure to allow investors to compare?
Total Return Determines the Resources Available to Income Investors
Income Investors too often focus on yield when evaluating potential investments when it is total return that actually determines available resources. It does an investor no good to receive a high yield from an investment if it loses a significant portion of its value and recent history has shown idiosyncratic risk can be painfully reconciled in securities pricing.
For investors looking to fund their day-to day lives, a better approach may be to focus on maximizing risk-adjusted returns and manufacturing a distribution. In this way investors are appropriately focused on their personal unitization of risk and return in their quest to efficiently meet their individual cash flow needs.
Figure 2: HANDLS™ Indexes vs. component constituent returns. Source: BAV, data Nasdaq Global Indexes
HANDLS™ Indexes: Distribution’s Efficient Frontier
- Approximately 70% fixed income and 30% equity, harmoniously balanced, to produce what is believed to be a sustainable distribution defined by long-term expected total return.
- Uniquely positioned as a benchmark for any high yielding strategy or multi-asset income fund because the rate is fixed by formula, not defined by pass-through.
- Built from a common optimized portfolio that relies upon the benefits of diversification to seek higher risk adjusted returns.
- Distributions can be calibrated to any target rate by applying a leverage (or deleverage) factor to the basket.
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