If We Could Only Buy 5 Funds Today For Next 5 Years

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Income investors should focus on decent income and total returns exceeding inflation by at least 4%, not necessarily matching S&P500 returns.Investing in funds like ETFs and CEFs can offer ...

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Also, we assume that income is the primary criterion for income investors, even though we all like to have decent overall returns. Recently, it has been increasingly difficult to match the S&P 500 (SP500) returns because the allocations in the S&P 500 have become skewed. Just the top 7 or 8 technology companies in the S&P 500 represent roughly 30% of its assets and have captured over 60% of the gains this year. This trend can obviously continue as markets are always unpredictable, but it is not likely to last forever. So, especially income investors should not always expect to match the returns of the S&P 500, as they can't afford to allocate 30% of their portfolio to technology stocks, which pay close to nothing in dividends. As income investors, we should have two goals, and if these two goals are met comfortably, we may not care so much about the S&P 500.  We are paid a decent income (as per our individual goals), which also increases over time to keep up with inflation. We can get a total return (on a long-term basis) that exceeds the rate of inflation by at least 4%. The total returns are calculated with the assumption that all income or dividends are reinvested. Also, we should aim to match or exceed the returns provided by a traditional 60:40 Stocks/Bonds portfolio.  With these goals in mind, if we also want just a few holdings, we obviously need to invest in funds and not individual stocks. When we say funds, they can be ETFs (Exchange-Traded Funds), CEFs (Closed-End Funds), or Mutual funds. There are several advantages of investing in funds:  Diversification: Funds can be great diversification tools. With one click of a mouse, you can get instant diversification into tens or hundreds of underlying stocks or securities. The same can be achieved in reverse when you sell a fund. Further, there are ETFs and CEFs available in so many flavors that you can easily diversify in different types of asset classes or different sectors of the economy. Ease of trading in and out: In the last two decades, ETFs have gained in popularity as they can be traded instantly (just like stocks) anytime during the market open hours, unlike mutual funds, which only fill up at the end of trading sessions. CEFs behave similarly to ETFs, except that their market price can vary significantly from their NAV (net asset value). Also, these days, most brokerage houses provide commission-free trades for ETFs and CEFs. Active management: Many ETFs can be passive and, in turn, charge a small fee. However, there are others that have active management but usually charge a higher fee.  With all that said, let's say we want to limit ourselves to just five funds because we want our portfolio to be truly passive and have as few positions as possible to maintain or worry about. Here are five recommendations for a fund only portfolio for the next five years. I. Schwab U.S. Dividend Equity ETF (SCHD) SCHD is probably the most popular dividend ETF out there. There are reasons why this is so popular. First is the relatively high dividend yield for the kind of large-cap holdings it has. It currently pays a 3.42% yield. The second reason is the dividend growth it had in the last 5 and 10 years. The dividend growth has been outstanding at 11.80% and 11.39% during the last 5 and 10 years, respectively. That kind of growth could turn the initial yield of 3.4% into over 10% yield on a cost basis in 10 years. Sure, there is no guarantee of similar performance over the next ten years. Also, the stock market had plenty of good years during the last ten years, and the S&P500 itself has grown 3-fold in the last ten years. In terms of total returns, SCHD has provided an annualized return of 11% (from June 2014 to May 2024) compared with 12.5% from the S&P500. That is expected because SCHD has only 9.3% exposure to technology stocks while the S&P500 has 34%, and we know that technology stocks have been on a tear for the last two years. Based on SCHD's history, we can be assured of a somewhat worry-free investment for the next five years, if not a decade. The Top 5 holdings of SCHD are Texas Instruments (TXN), Amgen (AMGN), Lockheed Martin (LMT), Coca-Cola (KO), and Pfizer (PFE). Chart-1: SCHD performance record: Growth of $10,000 Courtesy: Portfolio Visualizer We can see that the S&P500 outperformed SCHD, but most of that outperformance has come in the last two years due to a boom in technology stocks. II. Alerian MLP ETF (AMLP) As the name indicates, AMLP invests in MLPs (Master Limited Partnerships) in the energy sector. Most of these MLPs are engaged in the mid-stream energy business with large infrastructure in the form of pipelines, storage, and processing facilities. They carry out essential activities such as moving and storing hydrocarbons such as oil and natural gas. The ETF is based on the Alerian MLP Infrastructure Index. The underlying index and the ETF are both capitalization-weighted, which means the larger companies will have a greater share of the fund's assets. Having larger companies in greater proportions usually results in lower volatility. Even though these companies are not involved in the exploration or production of commodities, they still tend to get impacted somewhat when Oil & Gas prices are in a downturn, as we had seen in 2014-2016 and 2020. That said, the demand for Oil & Gas is not going anywhere for the foreseeable future, irrespective of the climate change targets of Governments worldwide. The ETF has an expense ratio of 0.85%, which is a bit on the higher side. It currently yields roughly 7.5% and has more than $8 billion in assets. Another advantage of owning the ETF versus the individual MLPs is that we will not have to deal with partnership income (K-1 forms) at tax time. The top 6 holdings account for over 75% of the assets, and the top 10 (all MLPs) account for 96% of the assets. Some of the top holdings are Western Midstream Partners (WES), Energy Transfer (ET), Enterprise Products Partners (EPD), MPLX LP (MPLX), Plains All American Pipeline (PAA), and Sunoco (SUN). III. Reaves Utility Income Trust (UTG) Utilities are known for providing higher income in the range of 4%. To elevate this income close to 8%, we can invest in one of the best quality utility closed-end funds. It offers consistent and reliable dividends and attempts to match the returns of the S&P 500 in the long term, though it may trail somewhat. However, in the short term, the performance could widely diverge from the S&P 500. Most income securities, especially Utilities, had a very tough couple of years due to the high interest rates environment, so the recent returns, like the past three years or five years, are not impressive at all. However, the trend is likely to change in 2025, if not in 2024. Meanwhile, we will get 8% income while we wait for recovery. Some of the top holdings are Constellation Energy (CEG), Public Service Enterprise (PEG), Deutsche Telekom (OTCQX:DTEGY), PPL Corp (PPL), CenterPoint Energy (CNP), NiSource (NI), Talen Energy (OTCQX:TLNE), and CMS Energy (CMS). Chart-2: UTG performance record: Growth of $10,000 Courtesy: Portfolio Visualizer In the above chart, we have taken the benchmark as 'Utilities Select Sector SPDR Fund (XLU)', but that is not exactly a good match for UTG. XLU is nearly 100% utility, while UTG is only 59%. Besides Utilities, UTG has 18% Communications, 8% Real-estate, and 7% each Industrials & Energy. IV. Cohen & Steers REIT & Preferred Income Fund (RNP) Now, real estate is such an important asset to hold, especially if you do not hold much of physical real estate. Real estate is often tied to inflation and cost of living. As the cost of living goes up (rather relentlessly), so goes the real estate. So, no portfolio would be complete or balanced without some exposure to real estate. However, a 10-15% allocation may be enough. So, we will go for a hybrid fund that combines two asset classes into one. We are combining real estate and preferred asset classes into one fund. RNP fits the bill quite nicely into this slot. This fund is invested nearly 50:50 into these two asset classes. As of Mar. 31, 2024, it had 52% in equities (mostly REITs- Real Estate Investment Trusts) and 48% in preferred and bond securities. The fund also uses some leverage of roughly 30%, which we do not like much, but the fund has generated quite decent returns over time. The fund was incepted 21 years ago (June 2003), and since inception, it has returned nearly 12.5% (annualized on a NAV basis). However, short-term returns are not that impressive, as we all know how difficult the last two years have been for income securities, particularly for the real-estate. We are close to the end of peak interest rates, and as it is widely expected that we should see at least five rate cuts by the end of 2025, the real estate is likely to recover nicely. The Top holdings of RNP on the equity (real-estate) side are: American Tower (AMT), Prologis (PLD), Welltower (WELL), Simon Property (SPG), Digital Realty (DLR), Invitation Homes (INVH), Realty Income (O), and Crown Castle (CCI). Chart-3: RNP performance record: Growth of $10,000 Courtesy: Portfolio Visualizer This is very similar to SCHD, where we see the performance is nearly identical until the end of 2022, followed by large outperformance by the S&P 500. We know the tech stocks are hot right now, and trends can continue for a while, but eventually, they reverse. V. JPMorgan Nasdaq Equity Premium Income ETF (JEPQ) Every investor needs growth in their portfolios, and that includes retirees and all shades of income investors. If an income portfolio declines year after year in value, it won't last very long and will no longer qualify as a worry-free income portfolio. You may have to start questioning how much income you should be taking out for this portfolio to survive. Moreover, if anyone says that retirees don't need growth in their portfolios, and they should spend all their money in their lifetime, they are absolutely wrong. The last thing that you want is not to have enough money in your 90s. So, it is better to leave some money to your heirs or other causes rather than having no money. This is where the funds like JEPQ come into play. It invests in large-cap growth stocks from the NASDAQ index. Sure, you could invest in Invesco QQQ Trust (QQQ) for the same reasons: it will give you growth but almost no income. JEPQ will give you exposure to all the same stocks but with substantial income. The primary objective of the fund is to deliver a high monthly income stream. The other objective is to get a significant portion of the total returns of its index with lower volatility. How does it do that? It does this by writing out-of-money covered call options on the Nasdaq-100 index on a portion of the net assets of its portfolio. Thus, it provides income to the shareholders by using some of the upside of the underlying holdings. The fund also uses a complex approach of using ELNs (Equity-Linked Notes) to write call options instead of writing straight-covered calls. The ELNs are derivative instruments that are designed to offer the economic benefits/loss of the covered calls written on the respective indexes. The other advantage of JEPQ would be that in case of a severe downturn, the downside will be restricted to some extent because of call options. Table-1: JEPQ comparison with Nasdaq-100 JEPQ Fact-sheet The fund's history is rather short, as it was commenced in 2022. Its sister fund, JPMorgan Equity Premium Income ETF (JEPI), which is based on stocks from the S&P500, has a slightly longer history. We are yet to see how JEPQ will behave in an outright crash situation. As we would expect, JEPQ is filled with large technology names, and some of its top holdings are Microsoft (MSFT), Nvidia (NVDA), Apple (AAPL), Alphabet Inc (GOOGL), Amazon (AMZN), Meta Platforms (META), and Broadcom (AVGO). Similar to QQQ, JEPQ has a 52% allocation to technology stocks. Regarding past performance, the record is too short to draw any conclusions. However, this is what it looks like for June 2022 to May 2024 in comparison with QQQ and the S&P 500. Chart-4: JEPQ performance record: Growth of $10,000 Courtesy: Portfolio Visualizer Portfolio Analysis: We want to know the overall allocation to different sectors. So, we start with a 20% (equal) allocation to each of the five funds and use the x-ray feature from Morningstar to analyze. We found that we had too much exposure to the Energy sector, nearly 27%. This was because SCHD has roughly 12.5% energy allocation, on top of AMLP being 100% energy. So, we reduced the allocation to AMLP from 20% to 12% and readjusted the rest of the allocations as per the table below: Table-2: 5 Fund Portfolio Author With the new allocations, we see more of a balance among different sectors. Even now, we can see some overweight in some sectors, but that is more by design due to this being an income portfolio. We can observe in the allocation chart below that we have the largest exposure to Energy, Technology, Utilities, Real estate, and Communications. All of these sectors (except Technology) are known to provide above-average income. The other sectors that are represented in high single digits are consumer (discretionary and defensive), industrial, healthcare, and financial services. Chart-5: 5-Fund Sector Allocation Author Concluding Thoughts: We regularly write on individual stocks and own many of them. But for so many folks, owning individual stocks may not make much sense. Some may not have any interest in reading or researching individual companies, while others may not have time. Even if they have time, they may have better things to do which are actually interesting to them. Also, as one gets older, especially nearing the 80s, it may be wiser to move to funds rather than individual stocks, as they are easier to manage.  Now, how many funds should you have? There is no single answer, and the answer greatly varies based on individual situations. How about just starting with five of them and holding them for five years? This was the thought behind the article. 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