Systematic Relative Strength

According to Morningstar, the whole idea of income-producing securities is flawed—and I think they are right. In an article entitled “Option Selling Is Not Income,” author Philip Guziec points out that option income is not mysterious free money. Option selling can modify the risk-reward tradeoff for a portfolio, but the income is part of the total return, not some extra money that happens to be lying around.

By way of explanation, he shows a chart of an option income portfolio without the reinvestment of the income. As you can see below, it’s pretty grim.

Source: Morningstar

(click on image to enlarge)

Why is that? Well, the plummeting line is the one where you spend the income instead of reinvesting it in the portfolio. So much for an income-producing security that has “free” income. In this graphic context, it is very clear that the income is just one part of the total return. (You can read the whole article—the link is above—if you want more information on the specifics of an option income portfolio.)

However, I thought the article was great for another reason. Mr. Guziec generalizes the case of option income funds to all income securities. He writes:

In fact, the very concept of an income-producing security is a fallacy. A dollar of return is a dollar of return, whether that return comes from capital gains, coupons, dividends, or option premium.

I put the whole thing in bold because 1) I think it is important, and 2) most investors do not understand this apparently simple point. This can be generalized to investors who refuse to buy certain stocks because they don’t “have enough yield” or who prefer high-yield bonds to investment-grade bonds simply because they “have more yield.” In both cases, income is just part of the total return—and may also move you to a different part of the risk-return spectrum. There is nothing magic about income-producing securities, whether they are MLPs, dividend stocks, bonds, or anything else. What matters is the total return.

From a mathematical standpoint, shaving 25 basis points off of your portfolio every month to spend is no different than spending a 3% dividend yield. Once you can wrap your head around this concept, it’s easy to pursue the best opportunities in the market because you aren’t wearing blinders or forcing investments through a certain screen or set of filters. If your portfolio grows, that 25 basis points keeps getting to be a bigger number and that’s really what matters.

This entry was posted on Thursday, October 3rd, 2013 at 1:10 pm and is filed under Markets, Thought Process. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.