Magnify Your Income With These 2 Great Funds

gerenme Co-authored Treading Softly. It’s natural to love a benchmark to compare yourself against. This is one reason why schools and the education system use standardized tests to evaluate each student against an established framework. When you join the military, there are tests to ensure that you meet the expectations of what you need mentally and physically to be an active member of the armed forces. Many employers have basic expectations that they lay out ahead of time and then judge you against them annually to see how much of a raise they should give you or to decide whether to give you a raise at all. When it comes to the market and retirement, many investors will be advised to use a 60/40 portfolio – 60% exposure to equities and 40% exposure to some type of fixed-income investment. Today, I want to compare a simple two-fund 60/40 portfolio versus the general market, specifically the S&P 500 (SPY), to illustrate how you can use two high-yield income-providing CEF (Closed-End Fund) investments to generate significantly more income than what the market would provide. Before I discuss these two funds, I will reiterate and remind investors that I do not support the concept of using just two investments to generate all of your income. Our Investing Group recommends holding at least 42 different individual income-providing investments. We call this our Rule of 42, and as such, I will encourage you that while we view these two investments as well worth having in your portfolio, they should not be what make up your entire portfolio. Let’s dive in! Pick #1: RVT – Yield 7.8% In the current market conditions, where major indices are largely driven by the Magnificent Seven and broader equity valuations do not exactly reflect the risks and challenges faced by the economy, we find that small-cap value stocks have been trading at historically cheap valuations (compared to the S&P 500 holdings) based on price-to-book values since late 2000. When the economy exhibits signs of fragility, it is important to hold investments with a good margin of safety, and there is nothing better than undervalued companies that form the building blocks of the overall economy. Interestingly, analysts expect small-cap earnings growth in 2024 to be higher than that of the large-cap counterparts. Source. Barrons The Federal Reserve will eventually be forced to cut rates, which will serve as a catalyst for improved small-cap profitability (and valuations) and for investors to rotate out of the market-dominating megacaps into this mispriced sector. Founded in 1986, Royce Small-Cap Trust (RVT) (formerly known as Royce Value Trust) is one of the few diversified funds that have successfully navigated through so many catastrophic economic and geopolitical phenomena. The single-day market crash, the Black Monday of 1987, the Savings and Loan Crisis of the late 80s, the Gulf War and oil price shock of 1991, the fear and horrors brought about by September 11, 2001, the DOTCOM bubble, the Great Financial Crisis, and the pandemic-driven recession are to name some of the most challenging times for America. But RVT thrived through these challenging times, just like America. RVT is deeply diversified across 431 holdings, with its objective to derive current income through active management of undervalued small-cap companies. The CEF is composed primarily of U.S.-based firms, representing 85% of the assets. RVT does not employ leverage in its investment strategy. “Our task is to scour the large and diverse universe of small-cap companies for businesses that look mispriced and underappreciated, with the caveat being that they must also have a discernible margin of safety. We are looking for stocks trading at a discount to our estimate of their worth as businesses.” — Chuck Royce. RVT has a variable distribution policy and pays distributions in March, June, September, and December. The CEF’s distributions are made at the annual rate of 7% of the rolling average of the prior four calendar quarter-end NAV, with the fourth quarter distribution being the greater of 1.75% of the rolling average or the minimum distribution required by IRS regulations. For FY 2023, the bulk of the distributions were fueled by long-term capital gains (86.7%), and 13% came from short-term capital gains. Author’s Calculations As income is the primary objective of the CEF, let us examine RVT’s income through the rocky COVID-19 economy, the inflationary effects of the government’s response to it, and the rapid pace of rate hikes we haven’t seen for decades (factors that are considerable tailwinds for a small-sized company). Source. Portfolio Visualizer From 2019 to 2023, RVT delivered an average 10.5% yield while outperforming its benchmark Russell 2000 index every year except 2022. We note that NII represented a minimal fraction of RVT’s FY 2023 distributions, so the fund’s distributions will depend on management’s ability to generate those gains sustainably and repeatably. The fund managers are closely vested in this objective of shareholder returns due to the rare caveat in the CEF’s fee structure. Advisor fees can increase or decrease based on the fund’s performance relative to the S&P 600 SmallCap Index benchmark. The fund managers will forfeit fees for any month when the fund’s performance over a trailing 36-month period is negative. We also note recent insider buying activity, strengthening the case for alignment between management pursuits and shareholder interests. Source. Marketbeat Today, RVT is priced at a 12% discount to NAV, making it a bargain within a bargain segment of the market, stretching your investment dollars significantly. RVT has delivered excellent total returns to shareholders for over 38 years, making it a good investment through economic uncertainties and a macro situation where small-caps are better positioned to outperform the market. Pick #2: PTY – Yield 10% PIMCO Corporate & Income Opportunity Fund (PTY) is PIMCO’s flagship fund. PIMCO is my favorite fund manager for all things debt. For decades, PIMCO has proved to be a fund manager who is willing to take advantage of unique opportunities and often takes contrarian positions. When other debt investors are running away in fear, you will often find PIMCO to be on the other side, buying their assets for pennies on the dollar. PTY is a diversified fund, with exposure to numerous different asset classes. Source. PTY Website The largest segment is “High Yield Credit,” which is primarily corporate debt including bonds, leveraged loans, and privately placed debt. PTY frequently gets involved with what it terms “special situations” – scenarios where a borrower is distressed, but has valuable assets. PIMCO takes advantage of its size to get involved and negotiate a favorable outcome. When banks were dumping mortgages, PIMCO was snapping them up. PTY’s 13% exposure to non-agency MBS is primarily thanks to the mortgages that were dumped by stressed banks during the GFC. Today, we’ve noticed that PTY’s allocations to CMBS (Commercial Mortgage-Backed Securities) and the US Government (Treasuries) have been increasing. These are the areas that PIMCO has been adding to recently. This is what I love about PTY: I can let PIMCO drive and steer the fund, confident that they know where they are going, taking advantage of opportunities that I don’t have easy access to. Conclusion Holding RVT and PTY can be an outstanding means of generating high levels of income. The question is, how high? Well, if we were to hold a $1,000,000 portfolio starting in 2014 and have 60% exposure to RVT and 40% exposure to PTY, rebalancing annually to maintain those exposures when compared to the SPY — look at the vast outcome of income generation difference. Source. Portfolio Visualizer Every single year, this simple two-fund portfolio would vastly out-produce income compared to the SPY. Would the total return of the SPY be higher if you were to not withdraw any funds at all? Yes. This is largely understandable because a 60/40 portfolio having exposure to fixed income usually underperforms compared to a fully equity-based portfolio. We are focused on trying to out-produce income and produce strong income from our portfolio, without capital erosion. When it comes to retirement, producing high levels of income from real portfolios year after year is the goal that so many aspire to. With this simple two-fund portfolio, we can produce income nearing 10% annually and, over a 10-year period, have received over $1,000,000 worth of dividends compared to significantly less from holding just a simple market-wide ETF. While I don’t recommend only holding two individual securities in an entire portfolio, this can be a proof of concept that holding a portfolio with more investments but adopting a similar strategy can vastly out-produce the market in the one thing that you need most in your retirement — income. That’s the beauty of my Income Method. That’s The beauty of income investing.

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