NEW YORK (FMD Capital Management) -- Maximizing your portfolio returns should start with a disciplined approach to structuring your asset allocation.
Oftentimes we get caught up in adding to favorite holdings or carrying too high of an allocation to a single asset class, which can be less than optimal over long periods of time. Taking a wider view of your entire portfolio can be helpful in making sure that your holdings complement each other to achieve your investment objectives.
My preferred method of structuring an income portfolio for my clients is to use "sleeves" to define fixed-income, dividend paying equities, alternative strategies and cash. You may have also heard these sleeves referred to as buckets, silos or some other term to define a similar group of securities. I certainly didn't invent this strategy, but I find it helpful to organize and define the investments in my portfolio. Then, as market conditions change, I can expand or collapse the sleeves within my portfolio to suit what I believe to be the best risk-to-reward characteristics for any given environment.
Bonds are back in vogue this year because investors have realized the potential for deflation may outweigh the risk of rising interest rates. One thing that can't be discounted is the level of income, diversification and low volatility that is needed by retirees, pensions and a host of other conservative investors that utilize fixed-income.
Right now the bond sleeve of my income portfolio has approximately a 55% allocation to a variety of exchange-traded funds and actively managed mutual funds in a number of sectors. Two of the top-performing funds that I have owned for quite some time are the Pimco Income Fund (PONDX) and Osterweis Strategic Income Fund (OSTIX) - Get Report.
I like these positions because they are focused on short-duration securities and have the flexibility to shift their holdings in response to the manager's tactical outlook on credit, duration, or interest rate moves.
Another recent addition to my bond sleeve is in the area of emerging market credit. The iShares JP Morgan USD Emerging Market Bond ETF (EMB) - Get Report has been slowly gaining ground of late and offers an attractive 30-day SEC yield of 5.19%. I think that the current interest rate environment will remain accommodative in the near future and additional upside in emerging market credit will likely be fueled by the continued demand for high yield assets with more reasonable valuations than developed nations.
Turning to the equity portion of my income portfolio, I have included a diversified mix of sectors that allow for both growth and income. This sleeve currently represents approximately 20% of my total asset allocation.
One of my favorite core holdings is the First Trust Nasdaq Technology Dividend Fund (TDIV) - Get Report, which gives you exposure to a subset of technology stocks that are focused on returning value to shareholders through cash dividends. The current 30-day SEC yield on TDIV is 2.65% and dividends are paid quarterly to shareholders.
One of the advantages of a fund like this is that it provides exposure to companies that aren't as tied to the interest rate cycle as traditional dividend paying sectors such as utilities. Technology stocks have started off 2014 on the right foot and I expect that trend to continue this year.
With the return of some additional volatility, I think that it makes sense to also have exposure to companies with lower price fluctuations than their peers. Another core holding is in the iShares MSCI U.S. Minimum Volatility ETF (USMV) - Get Report, which seeks to minimize exposure to the market's peaks and valleys by selecting stocks that offer less volatility than the broader market. USMV has a beta to the S&P 500 index of 0.84 as of the most recent ETF data.
I define alternative income investments as real estate investment trusts, preferred stocks and master limited partnerships, which have all blasted out of the gate this year. Right now we have approximately 12% exposure to this alternative sleeve in the form of funds such as the iShares U.S. Preferred Stock ETF (PFF) - Get Report and Fidelity Real Estate Income Fund (FRIFX) - Get Report.
These asset classes underperformed in 2013 but have been back in demand in the first six weeks of the New Year as falling interest rates have proved to be a tailwind for capital appreciation. Some of the advantages of these alternatives are that they give you exposure to asset classes with non-correlated returns and often higher yields than traditional stocks or bonds. That can translate into an excellent opportunity for diversification and a strong income stream as well.
As an active portfolio manager, I have always viewed cash as a safe harbor where you can shelter your portfolio when the storm clouds converge or temporarily store profits when investments hit your upside targets. However, the biggest mistake you can make with cash is holding too much of it for too long. That is oftentimes a signal that you don't have a true game plan in place for your portfolio.
Right now I have approximately a 13% cash position that I will be looking to deploy as various opportunities present themselves. It's always nice to have some dry powder on hand to put money to work at more advantageous prices. As long as the market continues to stay above its long-term moving average, I will likely deploy some of that cash in additional dividend paying equities or alternatives on a pullback.
On the flip side, if we see additional volatility rear its head, then my cash position will likely expand as stop losses are hit and I shift to a more conservative stance. The ability to adjust these sleeves in relation to market instability, risk tolerance, or cohesive price movement allows me to fine tune the asset allocation so that the portfolio is firing on all cylinders. The key to success is the implementation of minimum and maximum exposure limits for each sleeve so that you don't get caught with too much or too little exposure at any given time.
If you are interested in learning more about our four-sleeve approach to income investing, I encourage you to download our special report on The Strategic Approach To Income Investing.
At the time of publication the author had a position in EMB, TDIV, PFF and USMV.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.