Summary

• Many retirees have income needs that exceed the 4% one might expect from dividend stocks.
• Higher income yields can be had from several other asset classes including MLPs, BDCs, REITs and high-yield bonds.
• An alternative — or complement — to these investment vehicles is the closed end fund.
• A high-income portfolio of closed end funds can provide income in excess of 7-8% while being sufficiently diversified to provide a high level of protection for capital.

There is no lack of advice on Seeking Alpha for income investment in retirement.

One school of thought that is highly visible and highly vocal here is the Dividend Growth Investor community. While there is no rigorous manifesto for DGI proponents, there is a general theme that runs something like this: Invest in dividend paying stocks from well managed, largely blue-chip companies that have long histories of increasing dividends. By doing so, the mantra goes, one gets a growing retirement income that keeps up with (or beats) inflation without ever having to sell a stock. In its the most extreme incarnation, the dividend growth investor rejects all other asset classes. Many of its staunchest adherents profess complete indifference to market drawdowns that reduce their portfolio’s value on the premise that the dividends will continue to provide growing income. And it works until it doesn’t.

One problem is that many retirees find their retirement portfolios and their income needs are incompatible with the roughly 4% income yields a diversified portfolio of dividend growth stocks provides. All too often the advice from the DGI adherents is to lower your income goals. In effect the retiree is being told you don’t need that much income. Perhaps I’m overly sensitive to this sort of thing, but that seems just a bit condescending if not outright paternalistic.

The reality is that there many retirees who cannot get by on 4%. And their numbers will be swelling: the demographics of the baby boom insist they must. Fortunately, there are alternatives. There are very knowledgeable advocates of these alternatives here at Seeking Alpha. MLPs, BDCs, REITs, leveraged ETNs are among the most widely discussed higher-yielding asset classes. I have no issue with any of these investments. Taken together they can form a strong, high-yielding income portfolio and these, along with dividend growth stocks, form a significant fraction of my own retirement income portfolio. What I’d like to do here is discuss another investment vehicle, one that does not get anything near the attention of these others, but can, in my view, provide one of the most robust approaches to building a high-yielding retirement-income portfolio.

What is this super investment class? As you have undoubtedly guessed by now (of course, you’ve read the title and already knew, right?), I’m talking about closed end funds.

What I want to argue is that it is possible to create a productive income machine largely, or even entirely, from closed end funds. Chose an asset-allocation framework that makes sense to you and fill it out with CEFs. Do it wisely and you can expect income yield in excess of 8% while being sufficiently diversified to afford substantial protection to your portfolio’s capital value.

Income Efficiency

I’ll use some examples from my own retirement income account to illustrate the income productivity of CEFs compared to dividend stocks. I don’t want to make this a discussion of my individual portfolio, so I’ll just consider broad categories and a few examples. As I progress through the series I will probably expand on what I hold and why.

I began investing in CEFs as a means to ratchet up my income production, essentially using them to take positions in various asset classes while creating income well beyond what an ETF from that asset class could provide. Since I retired I have been slowing increasing my allocation to various CEFs. My goal is to create a portfolio of CEFs that provides broad diversification and an income of at least 8%. Currently my income account is generating 6.40%. CEFs account for about 42% of the holdings in this account; they produce 56% of the income. Dividend stocks, by contrast, account for 35% of the portfolio and generate 14% of the income. The weighted average yield of my CEF holdings is 8.55%, ranging from a low of 4.9% (TYY ) to a high of 13.53% (NASDAQ:OXLC ). For the dividend stocks the weighted average is 2.55%, ranging from a low of 1.29% (NYSE:CVS ) to a high of 5.82% (NYSEMKT:TIS ).

To give you an idea of how this plays out here’s a couple of pie charts from my retirement income portfolio spreadsheets:

One way to look at this is to compare what I call Income Efficiency which is the ratio of the two (%Income/%Holdings). Income efficiency for the dividend stocks in this account is 0.40; for the CEFs it is 1.34.

Diversification

Diversification is interpreted differently by different investors. I am not one of those who consider diversification to mean little more than holding domestic equities in a diversified array of sectors. That is, of course, an important consideration for the equity portion of a portfolio, but when I refer to a diversified portfolio, I’m talking about being diversified at the asset-class level.

Some will argue that they can forego asset-class diversification beyond domestic equities because they include such things as social security or pension income as filling the role of fixed-income assets. In addition, I have seen innumerable comments from advocates of the domestic-equity school of income investing who claim to be indifferent to declines in capital. I do not share either of these points of view. However, I am well aware that I am invested in holdings that do carry considerable volatility risk. My approach to modulating that volatility risk is asset-class diversification.

Most of what one reads on the subject of asset-class diversification is directed toward sustaining capital growth rather than income investing strategies. One can adapt the capital-growth models approach reasonably well to income investing by using withdrawals as part of one’s rebalancing strategy. This was, in fact, my original plan. However, that plan has evolved and instead I’ve turned to accumulating a diversified range of income-producing investments. Once again I’ll turn to my own portfolio to illustrate.

The portfolio is, in my view, too heavily weighted to equities and I have been gradually working to move funds into other asset classes. For one thing, I have been increasing my allocation to municipal bonds in this taxable account as I become subject to required minimum withdrawals from my IRA account.

One thing worth noting here is how the weighted average yield of the domestic and foreign stock asset classes compares to the weighted average yield of dividend stocks as an investment category noted above. That increase in yield comes from the equity holdings in the CEFs which contain 34% of the domestic equity and 32% of foreign equity holdings in the portfolio.

Portfolio Value and Capital Preservation

I hope I’ve made the case that a diversified portfolio of CEFs can generate a high level of income. Of course, seekers of high yields are repeatedly cautioned, perhaps chastised is a better word, for reaching for yield, an admonition that carries the implication that those high-yields will ultimately be paid for by severe capital losses. I readily accept that caution with regard to my ultra-high yielding holdings (included under other above) which I watch carefully and with a quick trigger finger. But I feel less concerned with regard to the CEFs. Not that I dismiss it, mind you, but I think it can be moderated with thoughtful diversification.

How to demonstrate that is the case is not so straightforward. There are many good proxy funds for almost any asset class that can be used to compare relative performances. But coming up with a workable proxy for the performance of a diversified portfolio of closed end funds is less straightforward.

With that caveat, I’m going to use YieldShares High Income ETF (NYSEARCA:YYY ) as a proxy. It comprises 30 closed end funds ranked on the basis of fund yield, discount to net asset value and liquidity. The asset mix approximates a 60:40 Equity:Debt mix at 58% Equity, 38% Debt and 4% Currency exposures. The chart below uses Morningstar’s CEF categories to describe the fund’s assets (source ).

It’s not perfect, but no proxy is. For one thing, the ETF is only 18 months old, so any comparison with domestic equity holdings matches a bull market in stocks against its diversified portfolio. Furthermore, I question several of the YYY choices. For example, it’s hard for me to understand how they can consider discount to net asset value as one of their three criteria, and include the likes of Pimco High Income Fund (NYSE:PHK ) and PIMCO Corporate & Income Opps (NYSE:PTY ) with premiums of 52% and 20% which together comprise 9% of the portfolio (source ). I’ll add as well that one pays double fees in this fund of funds, once to the CEFs and again to the ETF itself. This would not be the case for an individually managed portfolio of CEFs such as I advocate here.

Of course, variations of these criticisms will apply to any ETF proxy. The individual investor will routinely claim the astuteness to create an actively managed portfolio that will beat the passive index funds. Whether that is truly the case or not is, as we all know, quite variable. So, for the sake of comparison, let’s say these criticisms applies across the proxy spectrum and the flaws more or less even out, at least at a conceptual level. Thus, regardless of YYY’s flaws as a proxy, it is the closest match to a diversified CEF portfolio available, so I’ll use it here.

Comparing Income Asset Classes

Here’s how YYY compares to some ETFs that proxy for other high-yield income asset classes: Dividend stocks, SPDR S&P Dividend (NYSEARCA:SDY ); mREITs, Market Vectors Mortgage REIT ETF (NYSEARCA:MORT ); REITs, SPDR Dow Jones REIT (NYSEARCA:RWR ); High yield bonds, SPDR Barclays High Yield Bond (NYSEARCA:JNK ). SDY beats YYY for total return; none of the rest do. Keeping in mind that this is a diversified portfolio, it performs reasonably well in my estimation.

And for income, let’s look at current distribution yields for these six funds:

Not a bad performance. Second place in total return and second place in income. You might want to compare how each of the two first place funds in those categories performs in the other.

Although YYY has only been existence for a short time, the index that it is based on (ISE High Income Index (YLDA)) was backtested to 2004 (source ). I’ve plotted total return for the index through the inception of YYY and YYY against the other proxy ETPs for each year going back to 2004.

YLDA was the most volatile during the 2008 financial crisis and its aftermath. There’s a heart-stopping drawdown in 2008, but for the intrepid investor who held on, there’s the strongest recovery in 2009. Since that time its returns are among the most stable.

The correlations among this group provide an interesting comparison:

For this analysis I’ve used data beginning at the inception of YYY through 30 May 2014. Notice how correlations are modest to low throughout this range of funds (supporting the argument in favor of asset-class diversification). This should suggest that a reasonably well-diversified, low-volatility portfolio could be constructed from these funds. I’ve had a look at how they combine using various MPT criteria and those results indicate that one can do just that.

One result of that analysis has some relevance to this discussion. When running this exercise I looked at optimizing the portfolio with no constraints (i.e. each asset could go from 0 to 100% of the portfolio) for optimum Sharpe ratio, Sortino ratio or Omega ratio. When I did so, YYY dominated all three. In fact for optimum Sortino and Omega ratios, the software returned a portfolio of 100% YYY; for optimum Sharpe ratio it was 85% YYY. I was surprised at the result and I suspect that it is a reflection of the asset-class level of diversification present in YYY relative to these other funds.

I’m not willing to make too much of this observation, however. As the total return comparisons above indicate, the recent past has been a period of low volatility for YYY relative to the performance of the backtested index. I did not run the index values in this analysis because the comparison funds do not go back that far, but it would be revealing to spend some time with those data. Regardless of such uncertainties, it is clear to me that the diversified portfolio of CEFs provides high level of income, good performance on a total return basis, and is reasonably stable at the entire portfolio level for all but the most extreme event of the last 80 years (and even there it managed a notably strong recovery).

Summary

What I set out to do here is lay out a case for building a high-income, retirement portfolio of closed end funds. I used examples from my own portfolio to illustrate the enhanced level of income such a portfolio can produce relative to a mix of dividend growth stocks. I further looked at the only ETF that invests in CEFs as a proxy for the performance of an individual investor’s portfolio of diversified CEFs.

The evidence strongly suggests to me that such a portfolio has the potential to produce a high level of income and can be diversified sufficiently to provide reasonable protection from severe capital losses. These results are, of course, subject to considerable criticism having to do with the validity of using the proxy, so they do have to be approached cautiously. Actual results will obviously vary depending on how well an investor can select among the many CEFs available.

For investors new to closed end funds, let me suggest two sources. Nuveen, a closed end fund management firm, sponsors a comprehensive web site and screener for closed end fund (here ). The data are frequently not as current as one would like, but it is the best available resource I am aware of. For each fund the site provides links to the sponsor’s web site where one can usually find the most current data.

I’ve also found Morningstar’s CEF analyses to be useful. Morningstar tends toward highly conservative approaches, which is worth keeping in mind as one peruses their site. They also have some valuable discussion essays on the pros and cons of closed end funds.

A third source is Seeking Alpha itself. There are several very knowledgeable observers of the CEF universe writing here. I’d recommend Doug Albo for equity CEFs primarily, and Steven Bavaria and George Spritzer for their coverage of debt/credit CEFs.

I intend this article to be the first in a series on this topic. In subsequent articles I expect to take up such topics as strategies for building the portfolio, diversification schemes, how to interpret discounts and premiums, what to look for when buying and selling CEFs, and moderating the various risk factors involved in CEF investing.

Finally, readers should be aware that I am an individual investor. I am neither an adviser nor do I have any formal training in financial analysis. I am only presenting information I glean from publicly available sources and try to do the best job I can in interpreting those data. Any investor who is interested in my results will, of course, want to do his or her own complete due diligence before investing.

Disclosure: I am long CVS, OXLC, TIS, TYY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.