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Niche Funds for Yield Seekers

Daring investors can round out their income portfolios with small--very small--dashes of real estate, energy, and utilities.

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Note: This article is part of Morningstar's November 2015 Income Investing Week special report.

Bonds and a basket of dividend-paying stocks comprise the lion's share of most income portfolios--as they should. After all, there are plenty of low-cost, well-diversified fixed- and equity-income funds to choose from.

That said, investors willing to take on sector-specific risk might add a fund from one of the typically higher-yielding parts of the equity market--real estate, energy, or utilities--to the fringes of a portfolio.

Here are a few fund ideas from each sector--along with a discussion of the inherent risks in each.

Real Estate Funds
Funds in Morningstar's real estate category invest in both real estate operating companies (REOCs) and real estate investment trusts (REITs). REOCs can reinvest profits back into their businesses, but REITs must pay out 90% of their taxable income to shareholders as dividends. Because of this legal structure, REITs usually yield more than the broader equity market and have become a favorite among real estate funds.

"Although REITs offer relatively attractive yields, they are still equities and are not suitable alternatives to low-risk investments," reminds analyst Bob Goldsborough. "In the past three years, REITs were about 41% more volatile than the S&P 500 and 4.5 times more volatile than the aggregate U.S. bond market." Slower-than-projected growth, setbacks in the U.S. economy, and rising interest rates all pose near-term threats.

For investors comfortable with those risks, Vanguard REIT Index (VGSLX) and     Vanguard REIT ETF (VNQ) are attractive options here. Yielding 3.92% apiece as of this writing, they are among the least-expensive ways for investors to get exposure to the healthy yields that REITs offer. "Vanguard's managers and traders have done a fine job hewing as closely as possible to the benchmark, so this fund's return has never lagged its index by more than its expense ratio," notes Goldsborough. The mutual fund version earns a Morningstar Analyst Rating of Gold.

Schwab US REIT ETF (SCHH), another fine choice for exposure to REITs, carries the lowest expense ratio among REIT ETFs. Goldsborough notes that this ETF and Vanguard's maintain very similar portfolios, with an 82% holdings overlap. "Vanguard has a broader selection of REITs, but SCHH is an excellent alternative," he adds.

Unlike the other options mentioned here, DFA Real Estate Securities (DFREX) is not a completely passive fund. Although the fund doesn't engage in stock selection and buys all U.S. REITs and weights them by market capitalization, the managers do have the ability to adjust position weightings based on factors such as float, momentum, liquidity, and trading strategies. With reasonable costs and a solid long-term risk-adjusted performance, the fund earns a Morningstar Analyst Rating of Silver.

Equity-Energy and Energy Limited Partnership Funds
Though related, funds that invest in energy stocks and those that invest in energy limited partnerships aren't the same.

Equity-energy funds have direct exposure to upstream and downstream companies. Upstream companies, which tend to be more sensitive to changes in oil and gas prices, include companies engaged in drilling, exploration, and production, as well as equipment and services companies. Downstream companies, meanwhile, focus on processing and delivery, and include pipeline, refining, and marketing companies. These funds also buy the integrated oil majors, including BP (BP) and Exxon Mobil (XOM). Due to the diversity in their portfolios, equity-energy funds have held up a bit better than oil itself, though the average equity-energy fund is down more than 26% for the trailing 12-month period, as of this writing. As Morningstar's energy team noted in its most recent outlook, "Industry oversupply is making it very likely that crude markets will not approach any semblance of normalcy until 2017." And that oversupply could continue to weigh on energy stocks.

For those willing to accept the risks the sector carries, Vanguard Energy ETF (VDE) is an attractive choice. "This ETF represents an inexpensive and efficient way to invest in the U.S. energy sector without assuming too much idiosyncratic risk," notes analyst John Gabriel. The fund's 160-security portfolio offers diverse exposure to the integrated oil majors, as well as upstream and downstream companies. SPDR S&P Global Natural Resources ETF (GNR), a strong alternative, offers a more-concentrated play in the energy patch. With just 40 holdings, this fund carries more of a large-cap bias than Vanguard's offering.

Energy limited partnership funds, in contrast, invest in master limited partnerships rather than energy companies. (For a primer on MLPs, see John Waggoner's column for today). As such, these offerings have long been thought of as more insulated from energy-price volatility than funds investing directly in energy stocks. Yet, the average energy limited partnership fund has tumbled more than 28% during the past 12 months--a performance that's actually slightly worse than that of equity-energy funds during the same period. Investors have punished MLPs' share prices for three reasons, says Goldsborough. "For one, MLPs are not completely immune from commodity-price volatility, as roughly one fourth of industry cash flows are indeed commodity-sensitive," he says. In addition, investors have been spooked by the specter of rising interest rates, which they fear could result in a greater cost of capital for MLPs--and potentially, distribution cuts. For more about the risks of energy-MLP-focused funds, read this article.

Goldsborough discusses a trio of exchange-traded products offering exposure to MLPs here. Of the group, he thinks UBS ETRACS Alerian MLP ETN (AMU) is the best choice. "This fund provides broad access to a basket of energy-oriented MLPs," notes Goldsborough. Moreover, it tracks the same index as the largest ETP in the space, JPMorgan Alerian MLP ETN (AMJ), but because that product's creations are capped, Goldsborough prefers AMU. (Those interested can learn more about AMJ's unusual structure in this article.)

Two closed-end funds focused on energy MLPs receive Morningstar Analyst Ratings of Bronze, Nuveen Energy MLP Total Return (JMF) and Fid/Claymore MLP Opportunity (FMO). Both are run by the same advisor and follow similar processes. "The team has produced solid long-term returns by focusing on eliminating the riskiest MLP companies, according to its own five-factor score card, which looks at assets, financial strength, management, parent company, and diversification of business," says alternatives analyst Jason Kephart.

Thanks to their above-market yields and monopolylike characteristics, utilities stocks had long been referred to as "widow and orphan" investments. Yet, like other high-yield equity investments, these stocks are vulnerable during periods of rising interest rates, as lower-risk assets (such as bonds) begin to offer higher rates. "Environmental regulation and litigation also loom large," notes Goldsborough. So, while utilities present an above-market income opportunity, they, too, have their risks.

Among mutual funds, Franklin Utilities (FKUTX) earns a Morningstar Analyst Rating of Gold. "Low expenses and strong risk-adjusted returns make this an excellent utility-fund option," says senior analyst David Kathman. Managers John Kohli and Blair Schmicker invest largely in U.S.-based electric and natural gas utilities stocks. That sets this fund apart from many of its peers, which often dabble in nonutilities sectors and in foreign stocks. This relatively cautious stance has pushed the fund to the top of the utilities heap in tough markets and kept it in the middle of the pack during bull markets. It has, nevertheless, been one of the best performers in the 15-year period during which the current managers have been on board, with less risk.

Among ETFs, Utilities Select Sector SPDR ETF (XLU) is the most-liquid ETF investing in this part of the market. "It is a strong, appealing option for investors who want broad exposure to defensive, high-yielding United States utilities companies," says Goldsborough. The fund contains only mid- and large-cap U.S. utilities firms, as it only holds companies that are included in the S&P 500. "That means it owns more-stable utilities," adds Goldsborough. And because the fund follows a market-cap-weighting scheme, larger companies tend to hold more sway. "During periods when large- and mid-cap names outperform smaller-cap ones, this fund does better than an equal-weight option, while during periods where small- and mid-cap names tend to outperform larger utilities names, an equal-weight utilities ETF would perform better," he says.

Vanguard Utilities ETF (VPU) provides more-diversified exposure to this market, says Goldsborough. "VPU extends its reach further down the market-cap ladder and rests on a broader base of 81 stocks," he says. Despite its better-diversified portfolio, VPU exhibited volatility comparable to XLU during the past five years. And while this fund's 0.12% expense ratio is less than XLU's, this fund is less than one third its size, which may give it a wider bid-ask spread.

Susan Dziubinski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.