My core philosophy is called income investing. When implemented, investors enjoy dependable streams of cash created from stock dividends, bond interest distributions, and royalties. This generated cash could be reinvested to accelerate portfolio growth.
Our firm believes in this approach and uses it to help clients generate a “paycheck” like experience to fund future spending.
When implementing income investing, generally, money is allocated across four asset groups, or “buckets”: cash, income, growth and an alternative bucket. Of course, the percent allocation is market-dependent and goal-specific.
Today, I want to focus on this fourth and often overlooked bucket: Alternative Income.
Unlike the big three, this last group is glaringly absent in many retirement portfolios. Perhaps the name “Alternative Income” seems unapproachable. Or, maybe investors feel unnecessarily intimidated by the collection of unusual assets.
For whatever reason, this income producing opportunity area gets missed by investors. It rarely commands the headlines or makes news like the sexier growth plays like Amazon and Chinese internet powerhouse Weibo.
But attention is long overdue.
The Alternative Income bucket represents a mix of stocks and bonds that can enhance a portfolio’s overall yield – which is the cash flow from the underlying asset. When you consider that a portfolio’s total return equals growth plus income (TR = G + I), then it’s clear the impact that amplified yield can have on overall performance.
So, what assets are comprised in the “alternative bucket”? Here are four primary asset types included in the bucket.
Real Estate Investment Trusts (REITs)
REIT is a type of company that pools investor money to invest in a collection of properties or other real estate assets. REITs generally deliver the liquidity of stocks or bonds but offer investors fractional ownership in everything from apartment buildings, single family homes, data centers and shopping malls. These investments offer steady income from tenant lease and mortgage payments, while also representing an opportunity for long-term asset growth in line with real estate markets. Over the past 20 years, REITs have returned 10.9% annually, compared to 8.20% for the S&P 500 and often return more than headline sectors like telecommunications, health care or energy. While real estate is a savage business, REITs allow investors access to specific markets, geographies, sectors and asset categories. This mix means an allocation opportunity without full exposure like the usual real-estate property investor has.
Master Limited Partnerships
An MLP is essentially a publicly traded partnership that typically invests in energy transportation and infrastructure projects like pipelines, refineries and storage facilities. For tax reasons, investors become limited partners and receive quarterly cash distributions from the MLP’s revenue. MLP businesses can’t stockpile earnings and generally deliver more consistent and higher dividend income yields than many other income-producing investments. MLPs are conducive to companies in stable, but slow-growing industries that are capital intensive. The low cost of capital this structure provides allows MLPs to pursue projects not otherwise feasible for most taxable entities.
Historically, MLPs delivered boringly genius storage and “toll road” type businesses. Essentially, building infrastructure and charging for use of facilities and networks which was a stable and cash-rich model. But over time, they shifted toward high-risk operations like exploration and production; areas much more sensitive to commodity price fluctuations and volatility. As crude oil prices tumbled over the last few years, MLPs were hammered.
Today, many MLPs have returned to their servicing roots. Relatively low interest rates are keeping financing costs low, and as pipeline projects return to favor under the current administration, MLPs may be poised for growth.
Preferred stocks are a hybrid between stocks and bonds. Owners of preferred stocks have a higher claim on the company’s assets than common stock shareholders but are placed below bondholders. Among the resulting benefits: if the company pays a common dividend, it must pay the preferred stock owners their stated dividend before paying common shareholders. As a class, preferred stocks have been significantly less volatile than high-yield bonds or the S&P 500. As well, with characteristics like fixed-to-float duration where dividend yields are fixed for a period of time, investors can still reap income while staying protected against uncertain interest rate environments.
These mutual fund-like investment vehicles are listed on securities exchanges and bought or sold on the open market. Unlike open-end funds (or “mutual funds”) in the traditional sense, CEFs have a fixed number of shares outstanding. This means, their price isn’t only pegged to the value of their underlying assets but also moved by forces of supply and demand on shares in the fund itself. This presents unique opportunities for smart investors. CEFs can be bought at a discount, dividend yields may be higher and the funds may be better managed for the long term as fund managers don’t have the same liquidity concerns that open fund managers do.
Investors have come to know the big three portfolio buckets of cash, growth stocks and classic fixed income. Wading into the unknown of alternative income investing may feel a bit scary, but getting beyond tradition is often where opportunity lies. A portfolio’s yield and the prospects of future cash may well rest in enhancements made by REITs, MLPs, Preferred Stocks and Closed-End Funds.
Alternative doesn’t have to be scary, but like all investing, it requires time and education before jumping into the “alternative” bucket. As always, before investing, do your homework to determine if alternatives make sense for your unique situation.
To learn more about how you can introduce more income to your retirement, contact us today.
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