Fighting The Income Drought

So far, the fund has delivered on its goal to produce a consistently high level of income with less volatility than a typical balanced portfolio of stocks and bonds. It has provided a yield of between 4.48% and 5.52% since inception and has been about 30% less volatile than a 60/40 stock-to-bond allocation. Recently, institutional class shares, which have a net expense ratio of 0.55%, were yielding about 5%.

Shorter Duration, More Covered Calls And Hedges
About one-third of the fund is invested in developed market stocks in the U.S. and Europe. While Fredericks takes a positive view of the U.S. economy, he believes a stronger dollar will continue to be a headwind for U.S. companies that do a lot of business overseas. “U.S. stocks aren’t cheap, and there is reason to be concerned about how much more the market here can rally,” he says. “And because of the stronger dollar’s negative impact on exporters, we prefer U.S. companies whose businesses are based on domestic demand.”

Many of the portfolio’s holdings are in more economically sensitive consumer and industrial sectors, which tend to do well when the economy is on an upswing. He says the improving labor market, rising consumer spending and increasing capital expenditures all bode well for such stocks, and that these cyclical names “will lead the market in a rising rate environment.” On the other hand, he believes high-quality, blue-chip dividend payers, which investors have been drawn to for years, could underperform as demand for their defensive characteristics decreases.

Lately, Fredericks has been adding to the fund’s European stock holdings, which represent a little less than one-third of the total stock allocation. He believes that with the weakening euro and low bond yields, “equities are the most attractive game in town in Europe.” (He’s been using hedging strategies to iron out the currency swings.)


Covered call writing has become an increasingly important part of the fund’s strategy over the last year. With market volatility on the rise, premiums on covered call writing have become more generous since last summer, particularly for the cyclical securities he favors for the strategy. “We usually write calls that are 5% to 10% out of the money to reduce the chance of having the stock called away,” he says. “And if a stock goes up 10%, that’s the most appreciation we get, we’re satisfied.” Fredericks adds that the yield generated from the covered calls allows the fund to “be more conservative than we otherwise would be on the fixed-income side. Because of the income generated by covered calls, we don’t have to go to the bowels of the credit ratings to get good yields.”

Only 1% of the fund is devoted to master limited partnerships, well below its high of 8%. Fredericks isn’t fond of their commodity price sensitivity and says their partnership structure and lack of transparency make them difficult to analyze.

The fixed-income side, which represents about two-thirds of the portfolio, invests in a mix of high-yield bonds, mortgage-backed securities, investment-grade debt, cash, floating-rate loans and emerging market debt. At 15% of assets, high-yield bonds represent the largest fixed-income class, but that level is well below the fund’s historical peak of 55% and close to its all-time low of 12%.

Fredericks says low oil prices have hit high-yield bonds particularly hard, since companies that issue them are often in the energy sector. “And when equity markets sell off, high-yield bonds follow,” he says. “The risk-reward equation is more attractive in the equity markets than in high yield.”

At 13% of assets, the allocation toward mortgage-backed securities is at a historic high for the fund. “This is one of the few segments of the bond market where we think price appreciation is likely. Home prices are going up, which means defaults should decrease. And with the improving economy, wage inflation is creeping in.” Most of the fund’s investments are in bonds backed by mortgages from the 2004-2009 era, which Fredericks began picking up at a steep discount after the financial crisis in 2008. Although the bonds have appreciated since then, he believes they still trade at a discount to fair value.

He uses a barbell approach for investment-grade debt, which accounts for 14% of assets. At one end are short-term investment-grade bonds, which he views as a “cash proxy.” At the other end are intermediate and long-duration “AA” and “AAA”-rated securities, which he believes would hold up well in a bond selloff if investors fled to safety.

He recently upped the fund’s allocation to floating-rate loans, which represent about 3% of assets. He bought many of them after a selloff in late 2014 brought prices down, and he believes they could move back into favor once the Fed decides to push interest rates higher.

While he believes it is likely that the Federal Reserve will likely raise rates in June, rate increases will be gradual and concentrated at the shorter end of the yield curve. For that reason, he is hedging out interest rate risk for shorter-term bonds with U.S. Treasury futures and going long on bonds in the 10- to 30-year maturity range to pick up some extra yield. Using this mix of strategies, Fredericks has whittled down the fund’s fixed-income duration to a modest 2.1 years.