Yield Frontier


One of the most crucial questions for income investors is how much yield can realistically be achieved in real-world portfolios at different levels of risk.  What is the most yield that you can get with a portfolio which has one third of the total risk level of the S&P500, for example?  In answering this question, there is a key variable that must also be considered: exposure to changes in bond yields.  Some asset classes will tend to rise when bond yields are rising, and others will tend to fall.  I quantify this sensitivity using the correlation between a portfolio’s total return with the 10-year Treasury bond yield.  A positive correlation means that the portfolio’s returns tend to increase with rising yields, while a negative correlation means the opposite.

The methodology that I have developed compares the yields of a wide range of asset classes to their risk levels.  One of the first articles that introduced this approach appeared in Financial Planning in 2010.  I further developed the approach under the title ‘The Ultimate Income Portfolio’ at Advisor Perspectives–also in 2010–and I have followed up on the performance of the strategy and how the portfolios have performed in each year since.  The key theme is that we want to focus on portfolio characteristics that are measurable.  Yield is directly observable.  Risk requires some analysis but it is also measurable and past risk levels tend to be a good guide to future relative risk levels between asset classes.  I look at historical risk, as well as at projected risk using a portfolio simulation model.  The projected risk uses the relationships between asset classes to assist in coming up with expected future risk.  In addition, the emergence of options on ETFs provides an objective measure of expected future risk.  The prices of options depend on belief’s about future risk.  The implied volatilities of options give us an excellent check on risk levels.  We have three ways to estimate future risk, then: historical risk, simulated risk, and option implied volatility.  When these show consistent results, we have a solid estimate of risk.  The critical test is that the simulated risk matches the option implied risk.  The agreement is typically very good, which provides some confidence.

After coming up with expected risk levels and yields for each asset class, I then run an optimizer to identify the asset allocation that provides the highest level of yield for a given risk level and constraint on interest rate exposure (as measured by correlation to Treasury bond yield).  This is similar to the process used to create the ‘efficient frontier’ except that the traditional efficient frontier is optimized to identify portfolios with the highest return at each risk level rather than yield.  The efficient frontier of return vs. risk is problematic for decision making because expected return for each asset class is highly uncertain.  Past yield for portfolios is an excellent predictor of future yield (as opposed to total return, for which the past is not a robust predictor), so the yield vs. risk frontier is a far more useful analysis for making decisions.

In the tables below, I provide the yield and interest rate exposure vs. expected risk for each of a series of income asset classes, followed by the yields, risk levels, and interest rate exposures for the optimal yield portfolios.  I do not provide the actual allocations for the optimal yield portfolio here–this is a premium service–but an example of such portfolios analyzed in this framework is provided here.  Even without knowing the makeup of these optimal portfolios, this table is exceedingly useful as a benchmark that shows the income levels that are achievable in the current market conditions.

Individual Asset Classes

The starting point for analyzing the optimal yield portfolios is to assess the universe of possible asset classes for inclusion in an income portfolio.  A summary of the yield, risk, and correlation to 10-year Treasury bond yield for individual asset class ETFs is shown below.  This table is sorted on the basis of yield, with the highest-yield asset classes at the top.

The volatility and expected return are projected values from Quantext Portfolio Planner (QPP).  The yield is the current yield and the correlation to 10-year Treasury bonds uses three years of historical data.  The projected values use the most recent three years of historical data as inputs to QPP.

In general, bonds have negative correlations to Treasury bond yield and stocks have positive correlations to Treasury bond yield.

ETF Ticker Volatility Yield Correl to 10-Year Treasury Bond   Yield Expected Return
iShares Mortgage REIT REM 18.1% 15.3% -3.5% 9.8%
Wisdom Tree Global Real Estate DRW 23.6% 10.1% 17.0% 12.5%
SPDR S&P International   Dividend DWX 23.9% 6.5% 37.7% 12.7%
iShares High Yield Bond HYG 10.3% 6.2% 19.0% 5.9%
Alerian MLP AMLP 11.2% 5.9% 29.9% 6.4%
Market Vectors High-Yield   Munis HYD 9.5% 5.7% -48.5% 5.6%
iShares S&P U.S. Preferred   Stock PFF 9.0% 5.5% 20.3% 5.3%
PowerShares Build America Bond BAB 9.3% 5.1% -78.2% 5.4%
iShares Emerging Market Bond EMB 10.6% 4.7% -24.9% 6.1%
PowerShares Insured National   Muni PZA 8.4% 4.2% -73.8% 5.0%
iShares Corporate Bond LQD 7.2% 3.8% -52.0% 4.4%
iShares U.S. Utilities IDU 12.9% 3.1% -20.8% 7.2%
iShares Select Dividend DVY 10.0% 3.1% 25.8% 5.8%
iShares Cohen and Steers REIT ICF 20.3% 3.1% 11.3% 10.9%
iShares 20+ Year Treasury Bond TLT 17.6% 3.1% -90.0% 9.5%
iShares National AMT-Free Muni MUB 7.6% 2.9% -72.8% 4.6%
iShares Intermediate Credit   Bond CIU 3.9% 2.8% -42.8% 2.8%
iShares MSCI EAFE Index EFA 18.2% 2.7% 42.7% 9.9%
iShares Aggregate U.S. Bond AGG 3.7% 2.4% -86.1% 2.6%
Vanguard Total Stock Market   Index VTI 15.8% 1.9% 55.1% 8.6%
iShares MSCI Emerging Mkts   Index EEM 25.8% 1.8% 36.1% 13.6%
iShares 7-10 Year Treasury   Bond IEF 7.5% 1.7% -95.8% 4.5%
iShares Short-Term Bond SHY 0.7% 0.2% -58.9% 1.2%
SPDR Barclays 1-3 Month   T-Bill BIL 0.1% 0.0% -4.0% 0.9%

This table was updated in November 2013


Optimal Yield Portfolios

The process of creating optimal yield portfolios is quite straightforward.  Using the yields of individual ETFs (above), the risk levels of individual ETFs, and the correlations between them, I use an optimizer to determine the portfolios with the maximum yield, given constraints on total risk and correlation to 10-year Treasury bond yield.  I have limited the allocation to any single ETF to no more than 20% of the total portfolio.  There are two exceptions to this constraint: T-Bills (the proxy for cash, BIL) and the total stock market index (VTI).

The optimal portfolio outcomes are arranged by volatility and correlation to 10-year Treasury bond yield.  There are tables showing both yield and expected return.  If you are willing to take on a portfolio with volatility of 7.5% and you want zero correlation to changes in the 10-year Treasury yield, you can create a portfolio with a 6.5% yield, for example.

All ETF Portfolio Yield
Correlation   to 10-Year Treasury Bond Yield
Volatility 30% 20% 10% 0% -10% -20%
5.0% 3.0% 3.6% 4.0% 4.4% 4.7% 5.0%
7.5% 4.3% 5.3% 5.9% 6.5% 7.0% 7.3%
10.0% 5.5% 6.7% 7.2% 7.5% 7.9% 8.4%
All ETF Portfolio   Expected Return
Correlation to 10-Year Treasury Bond Yield
Volatility 30% 20% 10% 0% -10% -20%
5.0% 3.5% 3.6% 4.0% 4.2% 4.7% 5.1%
7.5% 4.8% 4.9% 5.4% 5.8% 6.3% 6.6%
10.0% 6.2% 6.2% 6.6% 6.7% 7.4% 8.0%

Optimal portfolios as of November 2013

The actual portfolio allocations that correspond to these results are available for a fee.



2 comments on “Yield Frontier
  1. Arnold Weiss says:

    In your excellent discussion of income asset classes. you present the history of some of them, but not nearly all of them.
    I’d be very interested to se how all of them have done over similar time periods.

  2. Buck Lansford says:

    I have been a fan of your work since Jan 2010, and have used your QPP Optimizer for years as well. I am impressed with your groundbreaking work on optimal income portfolio composition. I am always impressed with the level of thinking and analysis you apply to each topic you write about.

    With 8 years to retirement, I have built a portfolio of top-quality diversified dividend-paying stocks and MLPs, and am looking for more information on building the best income-producing portfolio with the least risk to insure a solid income for the rest of my and my wife’s lives. Thanks for your cogent contributions to the topic, and especially this new web site.

    Buck Lansford

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