For the last few years I have been running a small High Yield Portfolio (HYP) as an experiment. The performance of this portfolio has been underwhelming, to say the least. I’ve taken some time recently to dig into the performance in more detail to examine why the performance is so lacklustre.
The theory: take steady income, and gear up
The thinking behind my HYP was clear:
- Set up a HYP in a US dollar account. Let’s call it $100k to keep numbers simple.
- Gear the portfolio up. With USD interest rates at <2%, I was targeting a general level of gearing of about 2:1. I.e. I’d have about $200k of assets, and $100k of loan costing me around $2k per year.
- Pick securities, of any type, which had the following characteristics:
- Yield of above 4%. I have averaged yields of around 6%. This amounts to $12k of income (6% of $200k).
- A historically steady share price. Or, if I have to, a slowly rising price – e.g. AT&T.
- No obvious warning signs of impending doom.
- Reinvest income. I don’t have any particular science to this – sometimes I buy on dips, sometimes I add a new holding.
- Pay a modest amount for ‘volatility insurance’. My way of doing this was to hold a short position on the SPY tracker, amounting to about $20k. This reduces my loan by $20k but costs me about 2% too so it doesn’t really change my $2k per year total cost. My average in-price for that short position is 131, which tells you how old this portfolio is (hint: SPY is now at about 224!).
- In theory this would lead to a portfolio with $100k net asset value, average income of about $10k (i.e. 10%), and a manageable level of volatility. I think I might also expect some drop in capital value, if I’ve bought assets whose yield is because they are effectively selling off assets.
- This portfolio would not be tax-efficient because the gross income of $12k would all be taxable (and investment interest isn’t deductible in the UK) but even net of tax the level of return would be about 6%. This isn’t stellar but if it was reliable year after year I would be quite pleased with it. Ideally it would also deliver a modest level of capital gain too.
The practice: average returns of half my expectation
What’s actually happened is that this portfolio suffered a fair amount of scope bloat in the first couple of years. I added some UK holdings, and the portfolio grew to over 20 holdings. I realised this wasn’t teaching me much and started pruning it, culminating in a drastic rationalisation during 2015. For 2016 I’ve left the portfolio steady with six (unequally sized) holdings in it, shown (all, bar one – GEB – a GE bond yielding about 4%) in the graph below:
Over the last four years my returns are shown below:
On the face of it, hooray! I’m getting gross income of around 13%. Even after the interest (which is the cost of the 2x gearing), and the (USA withholding) taxes, my net income is above 9%. Every year.
But, alas, my compound return here is about 3.5%. Pre taxes. This is miserable. Why? Because I’ve lost about 6% of my asset value every year, on average – mostly due to a savage 21% drop in 2015.
What lessons can we draw here?
I’d welcome readers thoughts here. To mind it appears that:
- The gearing is working nicely on the underlying income.
- Looking back at my holdings in the early period, I got hit several times by big drops in hitherto steady asset prices. I think there’s a clear lesson here: above average yields signal above average risk – a greater than average chance that you’ll face a 10% drop in asset prices. Look what just happened to PSON (Pearson) this week – its >6% yield was a signal that the market expected bad news and sure enough a profit warning emerged which caused a 30% drop in the share price.
- My ‘volatility insurance’ isn’t doing much for me. And in truth I don’t think it’s the right protection for these sort of holdings. I’m going to change strategy and scrap the insurance but replace it with Stop Losses, set at about 10% below the holding price
Right now I view this portfolio as ‘on probation’. I ran it much more cleanly in 2016 and saw roughly the behaviour I’d have expected, with a 10% return. But in a year when S&P was up 10% this was still underperformance. If I can see 7% or more this year then I’ll see the average return climb above 4% and I’ll feel more confident I can explain what’s going on. If I take another pasting then I think it’ll be time to liquidate this portfolio and redistribute the funds elsewhere.
Any other suggestions here? How do your HYP portfolios perform, versus your trackers?