Invest In A SWAN Strategy: 5% Income, Lower Volatility, Solid Growth

Suwaree Tangbovornpichet/iStock via Getty Images Introduction: The broader market has been making new all-time highs. The S&P 500 (SP500, SPX) has gained 11% from the beginning of this year, and that is on top of the 26% gain last year (in 2023). So, by any standards, the market looks expensive. However, it is still possible that we might see the S&P 500 at the SPX 6000 level by the year’s end. However, the economy is giving mixed signals. The inflation is still too high for the interest rates to meaningfully come down. The likelihood of the Fed’s first rate cut in 2024 is still possible but fading away quickly. The economy is still growing, but most jobs that are being created have low wages. Consumers appear to be in a tough spot. Housing is expensive, both for renters and home buyers. The outstanding credit card balances in the U.S. are up 13% from a year ago to $1.12 trillion. So, in a nutshell, we seem to be at a crossroads. Will the good times in the market continue, or are we heading towards a cliff? Especially if you have fresh money to invest, it is a tough decision to make – invest or keep the money in cash. It becomes even more difficult for retirees and near-term retirees because they need a stable source of income but also need growth to fund as many as 30 or more years of retirement. So, retirees and other income investors need a portfolio structure that does reasonably well under all kinds of market conditions and continues to provide a relatively stable income stream. That’s what we like to call a SWAN portfolio. The Strategy: Goals of the strategy: We will start by defining some simple and realistic goals: First, by SWAN strategy, we do not mean compromising on growth. We should aim to achieve reasonably high growth that at least matches the S&P500 in the long term. Second, we would aim for low volatility, which will essentially help the strategy become a SWAN strategy. Usually, lower volatility conserves the investment and results in higher returns. Third, the strategy should aim for decent income (in the range of 5% to 6%), as this is the most important requirement for retirees and financial independence. A good amount of consistent income also helps the investor in riding any downturn without losing sleep. In this article, we will outline a strategy that should work reasonably well for both passive and active investors. We will have only TWO buckets in the strategy and divide our capital 70%:30% between the two buckets. The first bucket will be a DGI (Dividend Growth Investing) consisting of only 15 stocks. This bucket will aim for roughly 5% income and market-matching returns over the long term. The second bucket will be an Asset-based ROTATIONAL bucket that will provide the necessary hedging against deep draw-downs, recessions, and corrections. It will also provide the necessary growth to meet or exceed the performance of the S&P500. Why a DGI Portfolio with Individual Stocks? With a DGI portfolio, you have two choices. You could invest in dividend ETFs and funds, or you could pick 15-20 individual dividend stocks. With ETFs and funds, you always pay some fees, even if it is a passive fund. Obviously, you pay much more for funds with active management. Sure, there are many dividend ETFs that charge a minimal amount of fees; for example, SCHD charges only .09%, meaning you pay $9 for every $10,000 invested every year. With closed-end funds, or CEFs, the fees are usually a lot more. Also, with funds, they are usually over-diversified, and that means you get the good along with the bad, resulting in average performance. With an individual stock portfolio, you can avoid all such pitfalls. Moreover, you are controlling your portfolio. In that sense, it is for active investors and for those who do not mind reading and researching about their holdings. This is why it is recommended to keep the portfolio with no more than 15–20 names. Why a Rotation (Hedging) Bucket: The first advantage of a Rotation bucket is that it provides hedging without the cost of hedging, especially because trading costs have become zero in the last few years. So, what is hedging? A hedging strategy is a technique that seeks to limit risk exposures in financial assets. In fact, diversification itself is one form of hedging to limit the risk. The hedging technique that we are going to use is investing in different types of asset classes. However, we will only invest in an asset that has been doing well in the recent past and ignore the ones that are out of favor. We will do this rotation on a monthly or quarterly basis. The first advantage of having a Rotation bucket is that it can help reduce the volatility and draw-downs in your portfolio to a great extent. We also know that low volatility can enhance portfolio performance significantly over a long duration. Another important advantage of having a rotation bucket is that it can help avoid the “Sequence-of-Returns” risk for retirees or near-term retirees. This risk is defined as the risk of large negative returns occurring in the initial few years of your retirement or just a few years before your retirement. Usually, when that happens (large drawdown in the first few years of retirement), it becomes very difficult to recover from it, or it may take years to recover the losses. A hedging bucket can be helpful to keep the draw-downs in check. Lower draw-downs and volatility will help retirees avoid ‘Sequence of Returns’ risk and keep them in the game in the good times and bad. Two Buckets of the SWAN Strategy I. The DGI (Dividend Growth Investing) Bucket: We believe a DGI bucket is the foundation of retirement investing. Obviously, there are multiple ways to set up a DGI portfolio. However, in this article, we will structure our DGI bucket with 15 dividend stocks. Please note that our goal for this bucket is to provide reasonable growth, 5% income yield, and relatively low volatility. We will select at least 2–3 stocks with a high-growth potential. Most likely, they have to come from the technology or financial services industry. They should also be dividend stocks, even if the yield is low. A perfect example of this category would be a company like Microsoft (MSFT). Microsoft is the leader in personal computing, office & business software, cloud computing, and AI. Two other stocks we selected under this category are Texas Instruments (TXN) and Visa (V). TXN is in the high-growth semiconductor business but, at the same time, a consistent dividend grower. Visa, of course, is a member of the duopoly in the financial payment processing industry. We will also choose at least 3–5 stocks that are typically blue-chip, have a long history of growing dividends, and rank high in dividend reliability and consistency. Some typical examples and our selections would be PepsiCo (PEP), Clorox (CLX), Chevron (CVX), and LyondellBasell Industries N.V. (LYB). Now, all of these four companies are mature companies and have leadership positions in their respective industries. Their yield is generally in the 3-4% range, and we can expect reasonable dividend growth over time. Now, we will select at least 2-3 REITs from different segments of real estate with dividend yields in the range of 5%. We selected Realty Income (O), Gaming and Leisure Properties (GLPI), and Mid-America Apartments (MAA). These REITs will provide us with the necessary exposure to the real estate industry while at the same time providing us with good income. Realty Income is the monthly dividend company that has grown its dividends over 26 years. The last couple of years have been tough for Realty Income, and that has elevated the yield to nearly 6%. We think it is a good time to accumulate the shares. GLPI, as the name indicates, owns 61 gaming properties spanning 18 states in the U.S. GLPI is a slow-growing but very stable cash-flow generator. The average dividend growth has been slightly over 4% over the last 5 years, and the current yield is nearly 6.9%. The third company, Mid-America, is a Residential Apartment REIT with a 4.30% yield and A- credit rating. Most of its properties are in the Sunbelt region with high-growth prospects. We will also select a few names that are high-yielding (north of 7%). These can be some types of stocks that typically distribute most their earnings to stockholders, or they may be from some beaten down or out-of-favor industries. That said, their dividends are reasonably safe. Stocks that are selected under this category are Enterprise Products Partners L.P. (EPD), Ares Capital (ARCC), and Bank of Nova Scotia (BNS). The dividend safety and reliability of EPD and ARCC are quite strong, while BNS is mediocre. EPD is a master limited partnership and one of the best in the energy pipelines business. ARCC is one of the largest BDCs (Business Development Co). Both are likely to continue to provide stable dividends. Lastly, to ensure that we have high enough income from this bucket, we can pick some stocks that pay a very high yield, but the chances of growth are very limited. Some examples are British America Tobacco (BTI) and Canadian Communications co, BCE Inc. (BCE). BTI is mostly a contrarian play at this stage, and the shares are trading much below their fair value (according to Morningstar). BCE comes with the usual concerns of a very high level of debt (common in the Communication industry) and stagnant growth. Both yield close to 9%. Out of our 15 companies, all of them support the investment grade credit rating, but nine have A- or better. The average yield is comfortably over 5%. So, let’s take a look at the complete portfolio of 15 stocks: Table-1: High-Income Dividend Growth Stocks Bucket: Author II. Rotational Bucket (Hedging bucket): Asset-based Rotational Bucket: We have already explained the rationale for having a Rotational bucket. We are allocating the remaining 30% to this bucket. The selection of the pool of securities in this bucket is important. We want to have securities from different asset classes to ensure they move in divergent ways (with each other), at least the majority of the time. Basically, the correlation between them should be low. Sure, there will be times when they all move in the same direction, and that is okay. In our example, we will select securities representing various asset classes, such as Equities, Treasuries, Gold, Real estate, Commodities, and Cash (could be a money-market fund). List of six securities: Invesco QQQ Trust ETF (QQQ) iShares 20+ Year Treasury Bond ETF (TLT) SPDR Gold Shares ETF (GLD) Cohen and Steers Quality Income Realty (RQI) Vanguard Materials ETF (VAW). Cash (in the form of money market fund). Note: An example of a money market fund would be Fidelity Govt. Money Market Fund (SPAXX). Most brokers offer money-market funds. This will ensure that our cash earns some interest payments whenever it is left in the money-market fund. How It Works: At the end of each month, we will calculate the performance (total returns, including any dividends) of all the six securities over the last 3 months. We will then select the top two securities for investment in the ratio of 2/3rd and 1/3rd (the top performing will be 2/3rd while the second best will be 1/3rd). We keep this investment for the entire month and repeat the process. As an alternative, we could rotate (follow the above process) on a quarterly basis (every three months), but we will be slow in catching the trends. We can expect slightly lower long-term performance for the quarterly model compared to the monthly model. Backtested Performance – Rotational Bucket: We recognize that backtesting can be helpful only if it can go back at least a couple of decades (if not more) that cover some major corrections or periods of crisis. With the securities that we have chosen, we can go back to Jan.2006, covering well over 18 years. It also covers the 2008-2009 financial crisis and the 2020 pandemic, as well as other economic environments. Even then, it cannot predict the future, as the future will likely have some unforeseen events. But here are the results, whatever they are worth. Chart-2: (Monthly Rotation) Author Results with QUARTERLY rotation: The folks who find monthly rotation too overwhelming could opt for a quarterly rotation, but they should be prepared to settle for slightly inferior performance (although no one can predict the future). With quarterly rotation, the CAGR (Cumulative Annualized Growth rate) over the past 18 years came down to about 13.8% instead of 15.5% with monthly rotation and 10.17% from the S&P500. Table-2: From Jan.2006 – May 2024 CAGR Max Drawdown Model – Monthly Rotation 15.5% -27.8% Model – Quarterly Rotation 13.8% – 24.2% S&P 500 10.17% -50.97% Click to enlarge Also, please note that this particular Rotation strategy does not provide any income, but since we are rotating (selling/buying) securities every month (or every quarter), it is easy to withdraw 1.25% of income every quarter (or 5% annually). Let’s see backtesting results if we had withdrawn 5% of income (divided quarterly) adjusted for 3% annual inflation. The contrast with the S&P500 becomes even more clear in this case because of the deep drawdown that the S&P500 suffered during 2008-2009. Chart-3: Growth of $100,000 with 5% Income Withdrawals Author Concluding Thoughts Some readers will call this strategy complex, but if you properly analyze it, it is fairly simple. There is really one one-time effort to set up a DGI portfolio. Active investors can have individual dividend stocks, as presented in this article, while passive investors replace them with dividend funds. The second part, the Rotational bucket, only requires minimal effort on either a monthly or quarterly basis. Anyone can do it in less than an hour. Alternatively, one can subscribe to some service (like ours) that can provide you with all the information you need. Sure, there are always many ways to reach the same destination, and the strategy described in this article is just one.

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