ETF Income Investing for 2014, Part 3: Alternative Strategies

NEW YORK ( FMD Capital Management) -- In the first two articles of this three-part series on 2014 ETF income investing, I touched on my thoughts for fixed-income and dividend-paying equities in the New Year. I generally divide my strategic income portfolio into three sleeves that include bonds, dividend-paying equities and alternative investments.

This piece will focus on how to incorporate alternative strategies such as preferred stocks, master limited partnerships and REITs into your income game plan.

With the 10-Year Treasury note yield holding steady at approximately 3% and the Federal Reserve committed to a near-zero federal funds rate for the foreseeable future, income investors have to look for additional yield in unconventional places. Even a traditional dividend paying common stock is likely to only have a yield in the neighborhood of 3%, which may not cut it for a retired household that is looking to extend their savings for many more years.

The key to enhancing your income sources without taking an inordinate amount of risk is to carve out a small slice of your portfolio for avant-garde, dividend-paying sectors. Asset classes such as preferred stocks, master limited partnerships and real estate investment trusts can often be desirable because they do not correlate directly to equity or bond price movement.

This allows you to diversify your portfolio holdings into areas of the market that may outperform traditional asset classes under the right circumstances. They can also help smooth out volatility by somewhat offsetting the price movement of other securities in your income mix.

In 2013, the performance of these alternative strategies was a mixed bag. The area that saw the most strength was master limited partnerships, of which the Alerian MLP ETF ( AMLP) is still the biggest of the group with over $7 billion in total assets. The commodity sector had a volatile year; however, the income stream that MLPs derive from their infrastructure leasing and development has been rock-solid. AMLP gained over 18% last year and is currently paying a yield of over 6%, which is distributed quarterly.

One of the advantages of owning an exchange-traded fund instead of an individual MLP is you don't have to deal with the tax headache of a K-1 on your tax return and you get the benefit of diversification among a similar segment of companies. If the economy stays on track and commodity prices (i.e. oil and natural gas) stabilize, I expect MLPs will continue to perform well in 2014. However, they are susceptible to periods of volatility which is why it makes sense to have a sell discipline in place to define your downside risk.

Another area that I favor from a valuation standpoint is preferred stocks. The iShares U.S. Preferred Stock ETF ( PFF) hugged the flat line in 2013, but has many attractive qualities for income seekers. It is currently paying a yield of nearly 6% and behaves as a hybrid instrument with both equity and debt characteristics. In addition, it is still more than 5% off of its most recent highs which makes a better value proposition than many dividend stocks trading near their all-time highs.

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