The majority of ETF income investors focus their portfolios on dividend-paying stocks and bonds to generate yield. However, those traditional asset classes have now risen to the point where their income streams have fallen significantly. One strategy to overcome that deficit is to move down the credit spectrum or select speculative equity plays to supplement your core holdings. While that decision may result in short-term relief, it also introduces a significantly higher level of risk.

That leaves the door open for alternative income assets such as REITs, MLPs and preferred stocks to diversify your portfolio and enhance your yield. These often-overlooked income sources offer significantly higher dividends with the added bonus of uncorrelated price movement. In many instances, a measured dose of each can provide a counterweight to traditional stocks and bonds that lowers the volatility of your income portfolio as well.

The key to layering alternative income themes into your portfolio is getting a grasp on the factors that influence their behavior. Since nearly every asset that generates income can be loosely tied to interest rates, evaluating the intermediate-term direction of Treasury bond yields is an important factor. Observing interest rate movements should also offer insight into the relative value of alternative income assets when compared to owning bonds with low credit risk and high duration.

From there, you can dive into individual asset classes to gather insight on other collateral factors that dominate price fluctuations. For example, the majority of preferred stocks are issued by banks and insurance companies that are seeking alternative sources of capital outside the debt markets. In turn, the overall health of the individual company and the financial system as a whole are going to be the fulcrum of a successful investment outcome.

Preferred stocks are typically issued with call features or maturity dates that equate to long periods of time, such as 20-30 years. As a result, they happen to exhibit price movements that sympathize with long-term Treasury bond prices. The best time to purchase preferred stocks is typically after a swift rise in interest rates which adjusts a preferred stock’s price closer to its issue or call price.

Timing a purchase closer to the issue price reduces call risk and premium risk, and increases your income stream. In addition, rising interest rates can also have the follow-on effect of improving lending fundamentals for large banking institutions that issue preferred stocks, further increasing in investor’s margin of safety.

With yields typically double that of common shares, preferred stocks offer an excellent way to increase portfolio yield without increasing traditional equity market exposure. Our favorite way to gain exposure to the preferred sector is through the iShares Preferred Stock Fund (PFF), which has over $10 billion in assets, and currently yields 5.73%.

On the other side of the risk spectrum, REITs and MLPs offer attractive income streams but also can come with the expense of elevated volatility. The primary reason for erratic gyrations in prices typically relates back to the cyclicality of the economy.

For example, at its core, a REIT is essentially an entity that holds physical real estate. This structure enables it to transfer the earnings from rents back to shareholders as income. However, the price can be moved by changes in the value of the underlying real estate holdings, the loss of revenue from vacancy, or both. Therefore REITs typically perform best in an environment dominated by low interest rates to reduce funding costs, as well as high economic output to create scarcity and demand in the real estate market as a whole.

Arguably one of the best ways to gain exposure to REITs is through the diversified, low-cost Vanguard Real Estate ETF (VNQ). This ETF has over $23 billion in assets under management and a yield of 3.73%.

Oil and gas MLPs have a similar relation to REITS in that they typically own physical energy pipelines and deliver income to shareholders from those assets. Yet, MLPs are formed as partnerships rather than trusts, which can subject a holder of an individual MLP to receiving a K-1 during tax season. Investors can largely avoid this burden by owning MLP exposure through a mutual fund or ETF. However, it’s always best to double check the prospectus to clarify the details and taxation of any investment vehicle.

Carrying an allocation to oil and gas MLPs entitles the investor to a portion of the income derived from infrastructure such as pipelines, terminals, storage or transportation of crude oil, natural gas or other refined products. Therefore fluctuations in MLP prices can coincide with demand for the underlying commodity, supply side disruption or access to funding. Generally speaking, MLPs perform best in a strong economy with relatively low interest rates and a strong demand for energy products.

Depending on the type of MLP index, the yield and level of diversification can vary significantly. Two excellent choices include the actively managed First Trust NA Energy Infrastructure Fund (EMLP) and Alerian MLP ETF (AMLP).

Leveraging new income streams from alternative sources works to further diversify your portfolio away from more exposure to traditional bonds or dividend paying stocks. Furthermore, when it comes to managing risk in a steady income portfolio, seeking assets that exhibit lower overall volatility and have the potential to pay higher income streams can protect your portfolio from inflationary forces. Like any successful strategy, developing a plan and then implementing it decisively, will always yield the best results.

Download our free special report: The Ultimate Income Guide To Alternative ETFs

Disclosure: At the time this article was published, principals and clients of FMD Capital Management held positions in PFF and VNQ.

Related Articles
  1. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  2. Mutual Funds & ETFs

    The Democratization of the Hedge Fund Industry

    The coveted compensations of hedge fund managers are protected by barriers of entry to the industry, but one recent startup is working to break those barriers.
  3. Retirement

    Using Your IRA to Invest in Property

    Explain how to use an IRA account to buy investment property.
  4. Chart Advisor

    Now Could Be The Time To Buy IPOs

    There has been lots of hype around the IPO market lately. We'll take a look at whether now is the time to buy.
  5. Stock Analysis

    Why did Wal-Mart's Stock Take a Fall in 2015?

    Wal-Mart is the largest company in the world, with a sterling track-record of profits and dividends. So why has its stock fallen sharply in 2015?
  6. Investing News

    Should You Invest in Disney Stock Before Star Wars?

    The force is strong with Disney stock, as it continues to make gains going into the launch of EP7. But is this pricey stock a good buy at these levels?
  7. Mutual Funds & ETFs

    Top Schwab Funds for Retirement

    These Schwab funds are strategically designed and have performed well on a historical basis, meaning they're solid options for retirement.
  8. Investing News

    Silicon Valley Startups Fly into Space

    Space enthusiasts are in for an exciting time as Silicon Valley startups take on the lucrative but expensive final frontier.
  9. Chart Advisor

    Copper Continues Its Descent

    Copper prices have been under pressure lately and based on these charts it doesn't seem that it will reverse any time soon.
  10. Mutual Funds & ETFs

    American Funds' Top Funds for Retirement

    Planning for retirement in this economic and investment environment is far from easy. American Funds might offer an answer.
  1. Can hedge funds trade penny stocks?

    Hedge funds can trade penny stocks. In fact, hedge funds can trade in just about any type of security, including medium- ... Read Full Answer >>
  2. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
  3. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  4. How do mutual funds work in India?

    Mutual funds in India work in much the same way as mutual funds in the United States. Like their American counterparts, Indian ... Read Full Answer >>
  5. Are UTMA accounts escheatable?

    Like most financial assets held by institutions such as banks and investment firms, UTMA accounts can be escheated by state ... Read Full Answer >>
  6. What are the dormancy and escheatment rules for stock accounts?

    While the specific dormancy and escheatment rules for stock accounts vary by state, all states provide for the escheatment ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center