“Don’t be a yield zombie. An exchange-traded fund that yields more than 20% is just as risky as a stock that offers a similar yield.
“With interest rates at rock-bottom levels and equity markets enduring severe fluctuations, low-volatility income streams are scarce. Consequently, investors have resorted to unconventional income investments to boost their yields, especially in the realm of exchange-traded products (ETP). Consider the popularity of UBS E-TRACS 2X Wells Fargo Business Development Company Index (BDCL), a leveraged exchange-traded note (ETN) that delivers twice the monthly performance of the Wells Fargo Business Development Company Index. This index tracks a basket of 26 business development companies (BDC), publicly traded private-equity firms that invest in or lend to start-ups or small companies.
“Investing in BDCs is a dicey proposition in the current economic environment, but UBS E-TRACS 2X Wells Fargo Business Development Company’s trading volume has surged since it launched in April. In fact, the ETN’s volume is seven times that of the un-levered UBS E-TRACS Wells Fargo Business Development Company (BDCS). Although there’s an investment case for BDCs, these are speculative plays even before leverage enters the equation. In these fraught times, why would investors purchase levered shares of a fund that holds positions in companies with unpredictable earnings? The allure of a 20% yield is too difficult to resist. The interest in high-yielding ETPs is understandable; these instruments generally offer broad diversification at a low cost. But like every investment, these ETPs entail risk. And these risks are magnified when a fund employs leverage. A number of ETPs offer attractive yields with acceptable levels of risk—though investors should resign themselves to yields that are less than 20%.
“SPDR S&P International Dividend (DWX – yield 6.80%) currently yields [almost 7%], largely because of its broad exposure to Europe. About 58% of this exchange-traded fund’s (ETF) $554 million in assets are devoted to the region. Investing in European equities may seem ill-advised given the Continent’s ongoing sovereign-debt crisis. But Europe’s policymakers have already begun to take actions to right the region’s economic ship. Furthermore, SPDR S&P International Dividend’s focus on quality names provides investors with a measure of security. Although the fund tracks 100 of the highest-yielding common stocks in its coverage universe, it doesn’t blindly invest in the companies with the highest yields. Portfolio companies must have a market cap greater than USD1.5 billion and positive earnings growth over the trailing five- year period. The shares of these companies must also be extremely liquid. The economic turmoil of the past few years has narrowed the fund’s European exposure to defensive sectors such as utilities and consumer staples. Although the fund currently allocates 10.8% of its assets to the financial sector, Asian and Australian names account for the bulk of that exposure. European financial stocks represent only 0.7% of the ETF’s portfolio. The ETF is slightly more volatile than the S&P 500. But we believe Europe will stabilize eventually, which justifies the fund’s slightly elevated risk. With an expense ratio of 0.45%, SPDR S&P International Dividend is a buy up to 51.
“Preferred shares fall squarely in the middle of the risk spectrum; senior to common stock holders, preferred- stock holders are paid out after bond holders. Preferred shares don’t offer the same potential for capital appreciation as common stock, but they currently offer superior yields to many bonds. IShares S&P US Preferred Stock Index (PFF – yield 7.00%) holds a basket of about 240 preferred issues. The ETF’s [7%] yield is superior to the yield offered by the typical junk-bond fund. With a beta of 0.88, the fund is also less volatile than the S&P 500—a welcome respite from the wild swings in equity prices. Financial- services firms have long accounted for the lion’s share of publicly-traded preferred stock. Designed to track an index that represents the universe of preferred shares, the fund allocates 80% of its assets to the financial sector—a major turnoff for many investors. ... But the risks are acceptable so long as you hold the fund as part of a well-rounded portfolio. IShares S&P US Preferred Stock Index rates a buy under 40.
“Fiscal policy in much of the developed world has been reckless and profligate. By contrast, many emerging- market governments enacted prudent policies after they experienced their own financial crises in the 1980s and 1990s. ... Economic growth across much of the developed world will remain sluggish over the next few years. But emerging markets are the golden boys of growth. Despite fears of a slowdown in China’s economic growth, the Chinese economy will likely expand by more than 9% annually. ... All of this adds up to a weaker greenback and stronger local currencies in emerging markets. The U.S. dollar has appreciated relative to a basket of global currencies in recent months, as nervous investors have fled to safety. But this trend will reverse once worries of Europe’s sovereign-debt crisis subside.
“Market Vectors Emerging Markets Local Currency Bond (EMLC – yield 5.40%) is an income-seeking investor’s best bet to profit from these developments. The ETF’s portfolio comprises more than 180 sovereign bonds issued by 14 emerging-market governments. More than 75% of the fund’s holdings receive an investment-grade rating from one of the major bond rating agencies. The average debt-to-GDP ratio of the nations represented in the portfolio is 19.6%. ... The fund currently yields about 5.5% and charges an annual expense ratio of 0.49%. Better still, the holdings are denominated in local currencies, which will provide an extra boost as the greenback weakens. Offering an attractive payout and a hedge against future weakness in the U.S. dollar, Market Vectors Emerging Markets Local Currency Bond is a buy up to 28.”
Elliott H. Gue, Personal Finance, 11/9/11
