SVOL - 9% Yielding Portfolio To Crush The Market

2023-11-06 12:27:31 ET

Summary

• It is possible to build a high yield portfolio and substantially beat the market (S&P 500) on total return.
• Aggressive yield growth is possible for even a high yield portfolio.
• A quality high yield portfolio does not shrink but can grow your principal beyond inflation.
• I share the approach, selection criteria and constituents of my income portfolio.

Investment Thesis

Contrary to popular belief, it is possible to build a quality high yield portfolio to provide a consistent and growing income stream and still beat the S&P 500 in terms of total return and yield growth. The focus is on accumulation and growing the portfolio over the longer term and the subsequent income stream as oppose to the capital gains approach. Everyone needs income to pay the bills or invest to later pay the bills. The challenges with relaying on capital gains are numerous and include aspects like: When to buy? When to sell? How much to sell? What to buy next? When to buy next? What will the general market direction and the impact of economic and geopolitical risks be in the coming months or years? What if you sell too early or too late? All these questions are increasing the probability of sub-optimal choices. In this article, I share the approach and criteria for building my high yield portfolio with constituent details. Analyses of performance metrics are also clearly shown to support the mentioned points.

General Approach

The general approach in building the portfolio is based on a few principles including high yield without compromising principal as declining principal will ultimately lead to declining income. The income stream need to grow at least at the pace of inflation in the long run and be able to keep growing in retirement without additional investment. Over diversification is avoided as it could lead to lower quality investments. The approach requires an extremely selective focus on top quality and best among peer selection to achieve market beating high yield. This focused portfolio is not a selection from perfect hindsight but a real life portfolio build up over the last 43 months. Past performance is not a guarantee of future results, but it does count for something. The intention is to accumulate assets with growing income streams over the long term with the option to adjust if and where needed.

Selection Criteria

Criteria are somewhat flexible with no absolute hard and fast rules but rather an integrated framework. Investments are considered in the bigger context of sustainable dividend and dividend growth. Factors supporting the primary investment objective of long term dividend & distribution sustainability and growth without compromising principal are guiding the selection of investments in this portfolio.

Single company stocks are considered higher risk and are generally avoided. Over diversification within a particular fund can sometimes lead to lower quality inclusions so highly focused funds can often support investment objectives while effectively mitigating the risk exposure of single company stocks.

Factors like underlying debt levels, underlying future debt servicing ability and possible reduction plans, underlying earnings growth forecasts, underlying dividend / yield growth probability, future success of fund managers and possible impact of future interest rate trends are considered for impacts on each portfolio candidate.

The probability of future performance is important. Careful assessment of price and yield performance over certain “stress” periods in the past like the GFC, Covid and recent high pace interest rate increases. Long term sustainability of an investment with a balance of capitalizing on potential medium term strengths are considered.

Dividend / yield % maximization is important but with manageable risk. A combination of sustainability and future growth is key to avoid a high yield chase which rely a various sustainability factor projections. Dividend / yield growth over last 5 years should ideally exceed 10% CAGR although there can be exceptions. Dividend / yield % and dividend / yield CAGR are considered in combination as well. For sustainable ultra high yield, a lower yield CAGR can be accepted. Dividend / yield and related growth are considered over longer timeframes and bigger context as well.

The performance of a selected investment should loosely match the total return of a relevant benchmark (if any). If no suitable benchmark is applicable, then outperformance against peers is important. Multiple timeframes for performance comparisons are considered here with past 3 and 5 years important timeframes. Shorter timeframes are carrying less weight. Generally best in class is considered and this is an important factor to maximize quality and not over diversify portfolio with similar funds with lower performance.

Investments with only normal dividends are included as a class to avoid overexposure to derivatives and alternative investments but compromising on income %.

The screening and selection process are laborious with much research, comparisons and future estimates spanning a wide variety of sources including Seeking Alpha and the potential fund’s investor home page. Lastly, it must be noted that criteria for selection are applied with careful judgement within the context of future economic projections as well as the holistic profile of each candidate.

The Portfolio

Here is a list of the portfolio including the type of investment followed by a few highlights of each:

Capital Southwest Corporation ( CSWC ) is a BDC with a long track record (went public in 1961) but was changed to a BDC in 1988 focusing on private equity investments. A spin-off of CSWC’s portfolio to continue as a leveraged lender and investor was done during 2015. CSWC is also one of a few internally managed BDCs, which is preferred by many BDC investment experts. For example ARCC and MAIN are larger and popular BDC’s but did not adhere to the 5 year yield CAGR of 10% criteria. CSWC’s long-term price performance and yield characteristics are among the best in the space, but with a high current premium to NAV.

Harvest Tech Achievers Growth & Income ETF ( HTA.U:CA ) is a top performing ETF consisting of a very focused 20 large cap global technology stocks equally weighted including the popular names. The fund is a technology pure-play with no dilution of any other sectors. It has kept up with the Nasdaq 100 ( QQQ ) total return over most time intervals and even beating it over the past 1 and 3 years. Not many funds are doing this. Distributions are mostly from active covered calls. The share price and distributions are growing steadily over its more than eight year history. QYLD is a popular fund in this space but its total return over 3 & 5 years are 16.28% and 29.15% respectively in comparison to HTA.U:CA’s 53.48% and 119.28% (at close of market on Nov. 3 ^rd 2023). JEPQ is popular but still very young and returned 32.58% total return over the last year vs. HTA.U:CA’s 45.55% and QQQ’s 42.12%.

Hercules Capital ( HTGC ) is a 20 year old technology and healthcare rich BDC with a great track record. This 7 ^th largest BDC by market cap is a top total return performer over the last 3 years in the BDC space with a strong growing yield (although not meeting the 10% yield CAGR over the last 5 years) and price appreciation. It is carrying a heavy premium to NAV currently.

Oaktree Specialty Lending ( OCSL ) is a highly rated BDC and is in the top 10 (by net assets) with a forward yield of 11.45%. It has 75.5% of exposure to 1 ^st lien / senior secured loans. More than 83.6% of the loans in its investment portfolio are floating rate so it should benefit from a higher rates for longer scenario. It is currently trading at about 2% discount to NAV with a top 16.81% yield CAGR over the last 5 years .

Schwab U.S. Dividend Equity ETF ( SCHD ) is well known for its dividend growth from a healthy base (currently 3.85%). This large cap index fund only has a 0.06% expense ratio. Are you getting the maximum yield? No. Are you getting maximum total return? No. What you are getting is a low fee diversified large cap index fund with top dividend growth from a healthy base with decent capital appreciation and manageable volatility. It is hard to beat in its class.

Columbia Seligman Premium Technology Growth Fund ( STK ) is a CEF with a 19 year track record of matching the Nasdaq 100 ((QQQ)) in total return over most time intervals and even beating it over the last 3 years and a growing share price. It has roughly similar total return performance to HTA.U:CA but seen as a useful diversifier of fund manager and also contains about 70 constituents as oppose to the 20 of HTA.U:CA. It has a steady quarterly distribution policy supported by active covered call writing but is supplemented with long term capital gains resulting in a growing yield over the last few years not reflected in the distribution and distribution growth figures.

Simplify Volatility Premium ETF ( SVOL ) is an alternative ETF aimed at high income derived partly from shorting market volatility via VIX index futures. VIX call options are used to provide low-cost protection against extreme VIX spikes. Income is further supplemented by T bills, bonds and selective derivatives at the discretion of the fund manager. It is a relatively new fund, but the total return results are admirable: It achieved more than double the S&P 500’s over the past year (24.40% vs 11.65%) and 26.70% vs the S&P 500’s 9.55% since its inception in May 2021 up until September 30 ^th this year. Caution is warranted here as this fund may not be for everyone’s risk tolerance.

Cambria Shareholder Yield ETF ( SYLD ) was incepted in May 2013 and changed to an actively managed fund from June 2020. The portfolio consists of evenly weighted 102 mostly large to mid-cap U.S. stocks delivering high dividend payments and net stock buybacks with low financial leverage. The fund has exposure to a broad range of companies and sectors. No derivatives or leverage are used to enhance the performance of the fund. This ETF’s dividend growth rates ((CAGR)) over the past 3 and 5 years are 24.64% and 15.04% respectively, which are the best figures I have seen in its class. More details on this fund can be seen in my previous article here: SYLD SA Article

Yield Performance Analysis

The yield analysis is showing the Trailing Twelve Month Yield (at November 1 ^st 2023), Forward Yield as well as the Annual Dividend Growth rate on a 5 year CAGR basis. The average figures have been put in bold at the bottom of the table with SPY referenced for comparison.(Source: author's own analysis & SA Portfolio Comparison )

The average yield is six times that of SPY and the Annual Dividend Growth rate is more than double. This is providing some confidence in long-term sustainability and growth of the total income stream.

Total Return Performance Analysis

Here is a total return analysis of each of the constituents in the portfolio over the last 3 and 5 years. The average total return figures have been put in bold at the bottom of the table with SPY referenced for comparison. (Source: author's own analysis & SA Portfolio Comparison )

Substantial average outperformance of SPY can be seen across all time frames attesting to the quality of the portfolio and not losing out against capital gains via higher growth, lower yield investments.

Price Return Performance Analysis

This table reflects the price only performance over the last one, three and five years respectively. (Source: author's own analysis & SA Portfolio Comparison )

It is interesting to see the portfolio average easily beating SPY over the last 3 years. The price performance of the portfolio is providing confidence that the principal alone is more than keeping up with inflation.

Why should portfolio continue to perform?

Most of the constituents of the indicated portfolio are actively managed vehicles with a clear performance drive and incentive. The portfolio is effectively selecting top quality managers with proven track records of adjusting to changes in the environment to keep delivering. Just in the past few years we have gone through Covid, the highest inflation in many decades and the fastest interest rate increases in decades to name a few. All constituents delivered solid performance during all of these providing confidence that the performance will continue with the challenges the market will be facing in the future.

Risks to portfolio

It must be noted that even though a fair amount of resilience is built into the selection process of the portfolio, it is not immune to price declines. The income stream, however should be less prone to declines based on the future projections and underlying quality factors. Once again, the aim of the portfolio is not minimum price volatility, but rather a sustainable and growing income stream. The high income stream should cushion the effect of price volatility at least to some extent though.

Some BDCs (CSWC & HTGC) are currently trading at substantial premiums to NAV, which could add to price volatility. A better entry point into these BDC’s could mitigate some risk for new investors. The CEF ((STK)) is trading at around 8% premium to NAV currently and has a tendency to trade well above NAV at times in recent years adding to volatility. Once again an entry point close to NAV could mitigate some risk for new investors which would also increase yield on cost.

There could be a fair level of correlation of price downside shared within the BDC portion of the portfolio to take note of as well. The two technology funds (HTA.U:CA & STK) would also correlate through the typical up and down cycles experienced within the technology sectors. The two dividend growth ETFs and one alternative ETF does provide a fair level of diversity though, which could be further expanded on through additional funds.

The inclusion of a young (2.5 years old), alternative ETF utilizing shorting market volatility via VIX index futures as an income source does carry risk. VIX call options are used to provide low-cost protection against extreme VIX spikes to mitigate price downside risk, but caution is warranted.

Continued performance of fund managers and effective call writing cannot be guaranteed but are factors impacting on long term portfolio success.

General macro economical and geo political risks also apply and should be managed in accordance with individual investor risk tolerances. Having said that, the portfolio does not contain any single company stock reducing exposure risk accordingly. The indicated portfolio is built with a long investment time horizon with constituents owning quality investment metrics supporting future yield profiles and manageable drawdowns. This should minimize active management of the portfolio with the key focus on income stream sustainability and growth.

Conclusion

It is possible to build a relatively safe high yield portfolio substantially outperforming the market (S&P 500) on total return as well as yield growth. The yield growth could be sustainable well beyond the rate of inflation to address living expenses now as well as during retirement when reinvestment might not be an option. Price growth is also pointing towards long-term sustainability of the portfolio and addressing the concern of capital erosion, which is common with some high yield instruments. The indicated portfolio is a quality high yield example with a growing income stream in comparison to the complexity and potential stress of income via capital gains.

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