High Yields From Tricky Spaces

There are few free lunches in the world and fewer still among investments picked over every day by throngs of eager bargain hunters.

Experienced income investors understand that high yields are the required compensation for high risk, though of course that doesn’t mean a high-risk, high-yield investment can’t work out.

One way to mitigate some of that risk is to buy a basket of high-yielding securities. If they are all from the same industry the basket won’t avoid that industry’s hazards. But it will at least mitigate the risks unique to a particular stock, be they operational, managerial or financial.

That’s why exchange-traded funds can be a particularly useful tool for the income investor. The sectors with the higher yields also tend to be more complex. Emerging markets, mortgage REITs and preferred stocks are lousy with idiosyncratic risks not readily apparent to an amateur.

But each of those sectors can now be bought via ETFs that at least diversify that risk a bit. Here are three to consider, and possibly to own together as a further hedge.

The WisdomTree Emerging Markets High Dividend Fund (DEM) has a 30-day SEC portfolio yield of 4%, vs. 1.9% for the Standard & Poor’s 500 index. It’s also returned 20% so far in 2017, vs. 12% for the S&P 500.

To buy just the top 10 of DEM’s 313 holdings on your own, you’d need to shop the stock exchanges of Taipei, London, Hong Kong, Seoul and Johannesburg. Or you could just opt for the New York-listed DEM, at a reasonable annual expense ratio of 0.63% for avoiding that trouble.

Of course, the DEM still poses considerable risk. Four of its top five holdings are Russian or Chinese, and three of the five are energy giants. Companies based in Taiwan, China and Russia account for a hefty 55% of the entire portfolio. On the other hand, DEM’s tilt toward financial services, basic materials and energy – three sectors that account for half its assets – leaves it looking cheap relative to the emerging markets benchmarks, and poised to outperform if energy ever joins the commodity rally.

The Global X SuperIncome Preferred ETF (SPFF) offers a 30-day SEC yield of 6.9% from a portfolio of 49 highest-yielding U.S. and Canadian preferred stocks.

Preferred stocks tend to be less volatile the common equities and their payouts are considerably safer. The flip side is that there is very limited potential for capital appreciation and downside in the even of a significant rise in bond yields.  

Despite the hefty portfolio and distribution yields, SPFF has a total return of -0.6% over the last year, and 3.6% year-to-date. The top three holdings are preferred issues from Ally Financial (ALLY), Barclays (BCS) and Allergan (AGN). The annual expense ratio is 0.58%.

Near the top of the ETF yield rankings sits the iShares Mortgage Real Estate Capped ETF (REM). REM specializes in mortgage REITS, investment companies managing leverage portfolios of mortgage securities. The industry’s leverage makes possible REM’s 30-day SEC yield of 10.5%, but would cause trouble if short-term rates were to rise significantly, or precipitously.

Despite that risk, REM has returned 17% year-to-date. It has a 0.48% annualized expense ratio. The largest mortgage REIT, Annaly Capital Management (NLY) accounts for a whopping 18% of the capitalization-weighted portfolio. Next up are AGNC Investment (AGNC) at 10% and Starwood Property Trust (STWD) at 7%. REM’s entire portfolio is U.S.-based.

None of these ETFs guarantees a perpetual high yield unblemished by capital losses. But each offers a relatively rich and diversified income stream from sectors where single-security mistakes can be very costly.  There’s no free lunch here, but the ingredients are in place for a healthy meal so long as it’s properly portioned.