Current income solutions have become all the rage. Dollars are flowing into these mandates at an accelerating pace. Investment managers have responded by introducing a multitude of new product offerings in this isolated corner of the market. The investor stampede towards current income has two causes.

First, having endured a 12-year bear market for stocks, during which the realized return after inflation was approximately zero, investors have pretty much given up all hope. They have begun to settle for what they consider to be a second- or even third-best solution, that is, just receiving current income. Second, the baby boomers are retiring, entering the distribution phase of their investment life cycle. During this final phase, nothing is more important to them than receiving dependable current income.

Unfortunately, the rush towards current income has distorted this specialized corner of the market, both with respect to high dividend stocks and bonds  -- causing them to become overpriced. We can get a feel for the size of the stock market distortion by comparing recent returns for the general market versus those of the highest-dividend paying segments. For the period June 2, 2009, through August 20, 2012, the SPDR S&P 500 ETF (symbol SPY) returned 59.2 percent (unannualized), while the JP Morgan Alerian MLP Index ETN (symbol AMJ) earned almost twice as much, 104.2 percent, says finance.yahoo.com. This time window was chosen because it corresponds with the entire life of AMJ.

The bond market experienced an even more profound distortion. On June 2, 2009, the yields on 10- and 30-year U.S. Treasury bonds were 3.6 percent and 4.5 percent, respectively. As of August 20, 2012, these yields had fallen by almost half to 1.8 percent and 2.9 percent, respectively. This interest rate collapse resulted in unbelievable returns on U.S. Treasury bonds. During this period, the Vanguard Extended Duration Treasury Index ETF (symbol EDV) earned a 69.7 percent return, according to finance.yahoo.com.

The vastly superior performance experienced during this three-year period by bonds and high-dividend paying stocks fed upon itself in a self-fulfilling fashion. It served to reinforce investors' mistaken belief that chasing current yield was a better and more balanced solution  --  one that offered higher returns and lower risk. Unfortunately, what goes up must come back down. The rush to high-yield securities has overvalued this market segment relative to others. To compound an already over-priced market niche, investment managers have made the situation worse by introducing new investment products that take on greater and greater levels of risk in their desperate attempt to deliver high current income.  Today, we see new current income products that entail significant:

    Interest rate risk,
    Currency risk,
    Sovereign risk,
    Credit quality risk,
    Reduced dividend coverage, and
    Concentration risk.

This will end badly. Many investors holding current income products actually seek attractive total returns (as opposed to current income).  Something they have pleasantly realized over the last three years. Unfortunately, as interest rates rise, currency exchange rates move in adverse directions, sovereign nations default, credit quality deteriorates, and weak corporations reduce dividend payments, their current income products could experience surprisingly large negative total returns.

This is really too bad. It doesn't have to be this way. The right solution never overpromises and takes a holistic approach. If someone promises you high current income, no invasion of principal, stable account value, and an attractive total return, then you should be thinking of Bernie Madoff. You can certainly expect to dependably and confidently receive two of these, but you could never get all four at the same time.

The honest solution lies in breaking the link between these four competing objectives and never over-promising. Two quite viable and relatively conservative current income solutions could be characterized as follows:

Solution No. 1 achieves its objectives by focusing on:
    High dividend-paying companies that are best positioned to not only maintain but also grow their dividends,
    Investing in companies instead of in securities or products -- The so-called "Warren Buffett" approach (see www.berkshirehathaway.com),
    Unusually high diversification across these companies,
    Maintaining minimal exposure to interest rate reinvestment, currency, sovereign, credit default and concentration risks, and
    Minimizing the highly corrosive effect of embedded and hidden product fees and expenses.
Under the Warren Buffett approach, one focuses on investing in companies and businesses instead of in abstract securities  --  asking and answering the question, "Will this company thrive and successfully defend its relative position over the long term?"

Solution No. 2 offers even higher current income over a predefined time period, but at the expense of consuming the investor's principal. It achieves its objectives by focusing on:
    Eliminating the distinction between income and capital appreciation and instead distributing monthly income from the portfolio's total return  --  the so-called "Endowment Model" approach (see www.yale.edu/investments),
    Searching the world for the most attractive asset categories, fully independent of their current income levels and instead focusing on their anticipated contributions to the portfolio's long-term total return,
    Minimizing the highly corrosive effect of embedded and hidden product fees and expenses.

Under the Endowment Model approach, one adopts a highly opportunistic and broadly ranging active investment portfolio -- recognizing that opportunities and risks are always present, no matter what the environment, but are ever changing. It strictly avoids any notion of buy and hold and instead appreciates that tomorrow's solution will out of necessity be different from today's.

The baby boomer's search for attractive current income solutions is a logical pursuit. Unfortunately, the rush to existing current income products has had three adverse consequences. First, it has distorted segments of the bond and stock markets, causing them to be meaningfully overvalued and therefore significantly increasing their risk levels. Second, it has encouraged the introduction of new current income products that take on ever-higher levels of exotic risks in their desperate attempts to deliver high current income. Third, it has encouraged the false belief that the investor can have it all (high current income, no invasion of principal, stable value and high total return). Fortunately, honest current income solutions can be constructed following either a Warren Buffett or an Endowment Model approach4.

Rob Brown, PhD, CFA, is chief financial strategist for Eqis Capital Management Inc. He can be reached at [email protected].