ETF Expert

The volatility in the stock market rattles your nerves. And who can blame you… when the possibility of 50% price declines may be un-”bear”-able.

On the flip side, the bond market may have less going for it today than it has in many decades. For one thing, the current yield of a 10-year treasury is less than the dividends of utility stocks. SPDR Select Utilities (XLU) should arguably outperform 3.75% annualized over a decade. Moreover, with the Fed looking to remove stimulus — albeit slowly — rising interest rates kill the total return for holders of investment grade bond funds.

Are there in-between alternatives? Is there a sweeter spot where the risk-averse can get a shot at modest capital appreciation and higher-than-bond-like income?

Actually… there are. Here are several possibilities.

1. Preferred Stock. Granted, the media is beating Toyota and its Prius to a pomegranate pulp… so “hybrids” may seem risky. Yet preferred stock represents a unique share class that exists between common stock and bonds. Preferred shareholders must be paid their dividends before companies can even issue their common stock dividends. And in the event of a company going under, preferred stockholders get paid before common stockholders, but after bondholders.

It follows that the price of preferred stock moves quite a bit less than common stock, but a bit more frequently than bond prices; that is, when financial markets are acting relatively normal. Most preferred stock shares come from financial companies. With the possibility of the entire banking system collapsing, preferred shares were as scary as any market-based security from 9/08-3/09.

Today, however, with the financial system more stable, the biggest drawback for preferred stock is that it may be redeemed by the issuer. This resmembles the callable feature in a callable bond.

An exchange-traded fund like iShares S&P Preferred Stock (PFF) with 86 issues reduces the redemption risk through diversification; meanwhile, you collect the annualized SEC yield of 6.75%.

2. Master Limited Partnerships. Energy pipeline MLPs have been my diamond in the rough for many years. Pipeline MLPs typically transport crude oil and natural gas throughout the country, with supply and demand driving MLP price more than the commodities themselves.

Unlike common stock, MLPs are required to distribute high percentages of their revenue based on the unique structure and designation. While MLPs can expand through acquisitions, they can’t hoard cash and must distribute income to you, the limited partner. In fact, executive pay is often tied to distribution increases.

One big downside is extra tax paperwork, but that’s not an issue that would keep me away. Another downside is that extreme price fluctuations in commodities can increase the volatility of the Energy MLP space.

Last, but not least, the historical window of opportunity for “exceptional value” may be closing; that is, the yield spread between MLPs and treasuries may be best when the spread is greater than 3%, which means MLPs yielding less than 6.75% might begin to look less desirable.

An ETF/ETN that offers an approximate yield of 6.25% is the JPM Morgan Alerian MLP Index (AMJ). An individual MLP with a 7%+ yield and phenomenal “track” is Enterprise Product Partners (EPD).

Nevertheless, even as these income-oriented ETFs reduce a variety of risks for the yield-seekers, plenty of ETF risks may be present in your portoflio. How might a continuation of the U.S. dollar’s appreciation affect world stock ETFs? Will the falling ”euro” be  thorn in a variety of Currency ETFs? Has the sovereign debt crisis increased the risk of Foreign Bond ETFs? Find out more by reviewing ETF Risk Alert.

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