7-Funds Portfolio With $6,500 Monthly Income: Income Series

Introduction:

This article is for retirees and income investors. If you are young and have many decades away from retirement, you probably have better choices. However, income may be needed not only for retirement but also for other reasons.

For example, if you work for a job or business that is not highly secure, an income stream coming from your investments can provide a sense of security. Furthermore, if you are the type who wants to have financial freedom at a rather younger age, then again, an income-oriented portfolio could be great to get there faster. So, it all depends on your personal situation and goals in life.

How Much Income Is Enough?

This varies to a great extent, again, on your unique personal situation and what you are trying to achieve. If you are going to be retiring in a few years, then your goal would be to generate enough income for all your needs. Sure, you want to reduce it by any additional fixed income you are likely to get during retirement, for example, social security, pension, or some rental income.

However, if your goal is simply to attain financial freedom at a rather young age, your income goals should be such that it can meet all your basic needs, and it may not include all your wants.

All that said, we will make our assumptions for a retiree with a million dollars of savings. After some fixed income, our retiree’s needs are under $6,500 a month (or $78,000 annually, not including social security). We will now form a portfolio that can provide this income on a sustainable basis and without taking unnecessary risks.

Funds versus Individual Stocks:

The great thing about the Internet age is that we all have a lot of choices. We can form a portfolio of individual stocks with great ease without incurring any significant amounts of commissions. Most brokers offer commission-free trades these days. We can even have multiple portfolios with the same broker, each with a unique strategy or set of goals.

So, the good thing about holding individual stocks is that once you have acquired them, there are no ongoing fees or expenses, while most ETFs or mutual funds charge some amount of annual fees. For most index funds, the fees are usually very low, but funds with active management may charge significant fees. Most of the time, as an investor, you do not see these fees as they usually come out of the fund’s NAVs (net asset values). But all said and done, they come from your capital.

In spite of the above, in many situations, it may be advisable to invest in ETFs and funds rather than individual stocks. First, it is much easier to start a portfolio. Second, with one purchase, you are buying into tens if not hundreds of underlying stocks or securities, giving you instant diversification. So, now you do not need 30 or 40 individual positions in your portfolio to have proper diversification. You probably need less than ten funds.

How Can You Compound the Income?

We all know how we can compound our capital over time by investing in stocks or securities that can grow at a reasonable rate over and above the rate of inflation. So, what about compounding of income?

It can be best explained by an example:

For example, if you invest $500,000 at the age of 50 in dividend stocks, yielding an average of 4%, your income would be $20,000 a year. Now, let’s assume that these dividend payers grow their dividends at an average rate of 6% annually, which is typical for 4% dividend payers. By the time you are 62 years old, your dividend income will have doubled to $40,000 from the same portfolio. Obviously, you would have saved more during this time, which can now provide additional dividend income.

As a second example, let’s say, at age 50, you invested the same $500,000 into relatively safe stocks or funds, yielding an average of 8%, providing an immediate income of $40,000 a year. Now, these companies likely grow at a slower pace; we will assume that they will increase their dividends at an annual average rate of only 2.5%. In the next 12 years, at this rate, your annual dividend payment should grow to $53,800. Now, let’s have an even more conservative estimate for their dividend growth of only 2%; the dividend payment would still grow to $50,800 a year.

7-Fund Portfolio:

Here is the portfolio with seven funds with an average income yield of 8%, hypothetically generating roughly $6,500 monthly on a portfolio of $1 million. If income was not needed, the income could be reinvested to make the capital grow faster.

Table-1 (7 Fund Portfolio)

Portfolio Sector-Allocation:

Using the Morningstar X-ray, this is the sector allocation of the portfolio.

Chart-1:

The Individual Funds (in More Detail)

Fidelity Capital & Income Fund (FAGIX):

For the fixed income (or bonds) category, we like Fidelity’s mutual fund FAGIX. In fact, this fund falls under the “High-yield” Bond category. Its official benchmark is “ICE BofA US High Yield Constrained Index.” However, it is not all bonds; it has a history of some decent allocation (roughly 15-20%) to equities as well. It has been managed by the same manager, Mark Notkin, since 2003. The fund has a five-star rating by Morningstar, likely due to its solid long-term performance record. The fund has a long history and has provided an annualized growth of 9.34% since its inception in 1977, which is solid for a bond-centric fund. The recent performance is not that stellar, as it was a difficult period for bonds. For the last 3, 5, and 10-year periods, it has returned 4.66%, 8.37%, and 6.27%, respectively, and outperformed its benchmark by at least 2% points for each of the period. It yields roughly 5.2%. However, it must be kept in mind that this is a bond-centric fund, and its total returns are likely to be inferior to those of stocks. However, we are keeping an 18% allocation for retirees who need some diversification in bonds. Younger investors could have less allocation.

Enterprise Products Partners LP (EPD):

EPD is a diversified midstream energy company structured as a master limited partnership. It issues a K-1 tax form (partnership income) instead of the usual 1099 in case of regular dividends. It is probably one of the best-managed (if not the best) mid-stream partnerships. Also, this is the only one in our list of 7 which is not a fund but an individual company. We can certainly select some MLP-based closed-end funds, such as Kayne Anderson Energy Infra Fund (KYN) or Neuberger Berman Energy Infra and Inc Fund Inc (NML), which will also avoid the K-1 tax form and provide instant diversification. However, the problem with these funds is that they hold at least some mismanaged MLPs along with the good ones, resulting in a mediocre performance. But that option should be considered based on your situation.

The other solution is to hold up to 3 MLPs (instead of one) if diversification is needed. You could divide the capital into EPD, Energy Transfer LP (ET), and MPLX LP (MPLX).

EPD maintains a solid balance sheet with investor-grade credit rating and pays an attractive yield, currently at 7.2%. It has paid and raised the dividend payout since its inception for more than 25 years now. EPD has appreciated quite a bit in price this year, so it is not cheap. For this reason, it should be acquired in multiple lots with dollar-cost averaging. We can expect a very stable and close to 8% dividend payout from this dividend champion for the foreseeable future.

Cohen & Steers Total Return Realty (RFI):

RFI is a closed-end fund that primarily invests in equity and preferred securities of real-estate companies as well as REITs. The fund has a reasonably good long-term record of performance. Longer term, as of Dec.31, 2023, since inception in 1993, the fund has returned 9.44% on NAV basis, annualized, compared to 10.03% for the S&P500. However, the recent performance has been sub-par, but that is because the entire real-estate sector has performed very poorly in the last couple of years due to the high-interest rate environment. Our purpose to include this in our portfolio is two-fold. First, it will diversify our portfolio into the real-estate asset class. Secondly, it provides a steady and reliable income stream (on a monthly basis) and yields roughly 8.25%. Also, the fund uses zero leverage. Some of the top holdings are American Tower (AMT), Prologis (PLD), Welltower (WELL), Simon Property (SPG), Invitation Homes (INVH), Digital Realty (DLR), and Realty Income (O).

Reaves Utility Income Trust (UTG):

This is one of the best quality Utility closed-end funds. It offers consistent and reliable dividends and nearly matches the returns of the S&P 500, though on a long-term basis. A recent couple of years have been tough for most income-focused assets, including utilities. But that is likely to change in 2024 and 2025. Moreover, we get 8% income while we wait for recovery.

Liberty All-Star Equity (USA):

This is an equity-based closed-end fund that invests roughly 60% in value stocks and 40% in growth stocks. It uses the “Lipper Large Cap Core Index” as its benchmark. To some extent, it is akin to investing in the S&P 500 but with a high yield, obviously at some cost. It follows a managed distribution policy based on a formula. It distributes roughly 2.5% of its NAV every quarter as distributions. Due to its variable payout policy, the distribution can vary from quarter to quarter. The distribution policy makes sense because it tends to distribute less when the market is doing poorly and more when the market is booming. For a fee of 0.90%, the fund managers actively manage the fund, decide when to buy or sell, and capture capital gains to distribute the income.

On a very long-term basis, it has almost matched the performance of the S&P 500 (SP500). For example, from Jan. 1988 until Dec.31, 2023, the fund has returned 10.66% (annualized) on an NAV basis, compared to 10.79% for the S&P 500. Otherwise, it has provided returns that trail the S&P 500 by about ½ to 1% points.

Saba Closed-End Funds ETF (CEFS):

This pick may be a bit controversial. This ETF fund has a rather short history and has been around only since 2017. But it has a pretty good performance record for the last seven years. It also pays a monthly distribution of $0.14 per share, which accounts for roughly an 8.2% yield on the current prices. Also, it has paid this distribution consistently since inception without any interruption. In fact, it has paid year-end special dividends in five out of seven years. It should be noted that the fund uses leverage of roughly 14%, which is not excessive. The basic expense ratio is 1.10%, but after including the expenses of its holdings, the total fees add up to 2.90%. This is pretty much in line with funds of this nature.

CEFS ETF, incepted by SABA Capital Group, is an actively managed fund. Saba Capital is known to be an activist hedge fund group. Their primary strategy for CEFS is to trade closed-end funds opportunistically by capitalizing on the widening and narrowing of discounts/premiums. Moreover, it often takes up a position in a closed-end fund that it targets to improve management efficiency. This often leads to better outcomes in terms of narrowing discounts. One should invest in CEFS only if one believes in the capabilities and strategies of Saba Capital Group. Below is the performance of the ETF over various time spans.

Table-2:

JPMorgan Nasdaq Equity Premium Inc ETF (JEPQ):

JEPQ is an income-focused ETF offered by JP Morgan. The fund is fairly new and was launched in May 2022, though its sister fund, JPMorgan Equity Premium Income ETF (JEPI), has a slightly longer history since 2020. The fund is invested in large-cap growth stocks in the U.S. that are part of the Nasdaq index, and the income is supplemented by writing the covered calls on the index. It aims to get a significant portion of the total returns of the Nasdaq index with lower volatility. One of the primary objectives of the fund is to deliver a monthly income stream from the option premiums and stock dividends. The current trailing distribution yield is 8.94%. As expected, some of the top holdings in the ETF are large technology stocks, for example, Microsoft (MSFT), Apple (AAPL), Nvidia (NVDA), Amazon (AMZN), Meta Platforms (META), Alphabet (GOOGL), and Broadcom (AVGO).

It writes monthly covered calls on the Nasdaq Index using weekly tranches with OTM (out-of-money) strikes, which allows it to capture a reasonable (but not all) of the upside while earning decent premiums to generate income. The fund uses a rather complex approach of using ELNs (Equity-Linked-Notes) instead of writing actual calls. The ELNs that the fund invests in are derivative instruments that are designed to offer the economic benefits/loss of the covered calls written on the Nasdaq index.

Since it is an option-based product, in a bull market, the investor is likely to forego some of the upside of the underlying stocks, so overall, the returns will likely lag the index. But, at the same time, it is also designed to offer some protection during a down market. Another plus point is that by investing in JEPQ, we are getting exposure to a large number of high-quality large-cap Nasdaq stocks, while it commits roughly 20% of net assets to ELNs to generate income.

For some of the closed-end funds used above, you can read our recent detailed analysis reports here:

Likely Risks with the Portfolio:

Here are some risks with the above portfolio that the investors should be aware of:

• There is no downside protection. During the 2008-2009 financial crisis, this portfolio had a drawdown of roughly 48%, very similar to the S&P500. However, the difference was that a portfolio like this continued to provide roughly the same income during the crisis period. That should make it much easier to ride down any such period.

• Many of the funds in the above portfolio may be overvalued at this time. Some of them may be trading at a premium to NAV. One way to mitigate this risk is to buy in multiple installments using the dollar-cost average method.

• The market has priced in the expectations of multiple rate cuts in 2024 and 2005. However, if that somehow does not materialize or gets delayed due to sticky inflation, some of the funds in this portfolio, especially the ones with leverage and focused on a fixed income, will likely underperform. That said, one should invest in this portfolio of funds for a regular and dependable income stream and need to ignore the short-term price movements.

• Unexpected situations may arise as the future is always unpredictable, and the portfolio may not perform as we expect. The only way to mitigate this risk would be to monitor these funds at least periodically and make sure that nothing has changed fundamentally.

• Market risk: Obviously, there is a market risk with any such portfolio. If the broader market were to enter into a prolonged downturn, this portfolio would perform in line with the market. In certain situations, it could even perform worse. To mitigate this risk and allow a faster recovery, the investor should withdraw less income during the down market years and possibly more during the bull years.

Concluding Thoughts:

We usually write about individual stocks and personally invest in individual stocks, closed-end funds, and diverse strategies. That said, if you want to keep your investing process simple and straightforward but still diversified, the portfolio described above is an ideal candidate. This portfolio will provide you with high income with a yield of roughly 8%, which means a portfolio of one million dollars would provide you with $80,000 a year in income. After adding fixed income like social security or some pension, this portfolio could afford you a very comfortable retirement. Even then, we recommend that during the down market years, the investors should withdraw less than normal and reinvest the balance. This will allow the portfolio to bounce back from drawdowns and compound much faster.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.