Smart investors can't just ignore the risk that these investments carry, especially as the market enters its price-chasing phase, says Doug Fabian of High Monthly Income.
There's no denying the stock market has been on a big run higher of late, and the recent run of consecutive all-time highs for the Dow Jones Industrial Average is admittedly quite impressive.
Yet like all rallies, this one too shall pass. Most likely, it won't come to a slow, controlled stop. The most likely scenario is a slamming of the brakes, and an abrupt drop off the cliff for stocks.
This abrupt drop happened in 1987, when we saw the Dow plunge about 20% in a single day. In 1929, there was a 25% plummet in one day. Much more recently, in 2008, we saw a 50%-plus plunge in the market over just 14 months.
Before we go on, I want to be clear that I am not predicting such an ominous end to this current bull market. What I am predicting is that a lot of investors who have put money in the market recently are likely to get blindsided by a big correction.
For income investors who may not be allocated to stocks, there's another area of the market that's been on a run lately. That is high-yield alternative investments, such as master-limited partnerships (MLPs), real estate investment trusts (REITs), high-yield corporate bonds, preferred stocks, and so on.
To be certain, many of these funds have delivered a lot of upside price appreciation, along with attractive yields, so far in 2013. A case in point is the Alerian MLP ETF (AMLP). This energy infrastructure fund boasts a nearly 6% yield, and it's up about 6% during the past three months.
However, the fund also is susceptible to some hefty drawdowns. There was a huge pullback in AMLP that took place in May and early June, again in November, and yet again in December.
Yes, there has been some robust upside in this fund in 2013. But once the inevitable sell-off takes place, you will be glad you didn't chase the performance and yield in a fund such as this one.
To be certain, I like AMLP, and I think the energy infrastructure space is a good one for income investors. However, I need to see this fund—along with almost every high-yield fund—return to normalcy before I can recommend you take a risk and buy this sector with your income-generating capital.
One thing to keep at the forefront of your mind is that high yield also equals high risk. To see just how much risk there is in these kinds of funds, check out the data table below.
HIGH-YIELD ENCOMPASSES HIGH RISK
Here we see that, from their respective 2008 highs to their 2009 lows, these funds experienced a severe drawdown. High-yield corporate bonds, real estate, large-cap domestic dividend stocks, preferred stocks, utility stocks, and international dividend plays all got crushed under the weight of the big market meltdown.
Once again, I want to make it clear that I am not saying this is going to happen again soon. What I am saying is that a huge drawdown in these high-yield, high-risk plays is something that is a very real possibility.
What this situation means is that we don't want to chase these funds at what I think are currently quite lofty levels, as the drawdown factor would leave a lot of your income-generating dollars subject to way too much downside.