Composition and Weightings

The index is currently comprised of approximately 55% fixed income securities and 45% equities. In general, the index’s target allocation is 40% to 45% in equities and 55% to 60% in fixed income. The allocation will fluctuate within these targets depending on market conditions.

Fixed Income. The fixed income securities are a combination of high-quality corporate debt, agency, and U.S. Treasury bonds. The fixed income holdings provide for guaranteed income even in the most difficult markets, and a healthy dose of principal stability to protect the investor's total portfolio value. The duration of the bond portfolio is approximately 5 to 6 years. 

Equities. The equities consist of dividend paying stocks in the 10 major stock market sectors. The stocks are selected for their ability to not only pay a current and meaningful dividend, but for their ability to grow their dividend over the years. The financial strength of these firms provides both a reliable source of current income and a source of growing income to combat the effects of inflation.

The following chart illustrates the sector weighting for the equities in the FNRI Index.  The figures are current as of 1/29/10.  Weightings may change given varying sector performance, or at Northstar’s discretion.

Weightings

One important distinction of the FNRI Index is that the equities are equally weighted. We do this because the FNRI Index focus is on current and stable income. Each equity holding is selected for its individual ability to pay a meaningful dividend, maintain that dividend and grow that dividend. Thus, from a risk management standpoint, it is important to maintain an equal weighting to minimize the cash flow decline that might occur from a dividend cut.

Our equal weighting approach is significantly different than the market capitalization weighted approach taken by most other indices. In a market cap weighted index, the larger companies represent a larger percentage of the index, and thus a larger percentage of the index’s cash flow. Consequently, a divided cut or elimination from one or more large index holdings could significantly damage the index’s cash flow.  Moreover, dividend increases from smaller index holdings will have little impact on the index’s entire cash flow in a market capitalization weighted index.

Because the FNRI Index is primarily focused on stable cash flow and opportunities for growing cash flow (and not price appreciation), we equally weight our holdings, which provides investors with more income protection and stability.

The next graph illustrates our equity sector ratings relative to the weightings of the S&P 500 as of January 29, 2009 (not including our use of master limited partnerships; see above chart). Our weightings reflect our bias toward securities that meet the stated objectives of the index, including stable and growing dividends.  Thus, some sectors will have more representation than others because they are comprised of companies that meet the index objectives. We do, however, believe it is important to have industry diversification, and thus do have holdings in all 10 major stock market sectors.

One danger with certain indices that focus on cash flow from equities is that they tend to be concentrated in a few sectors because they are often chasing high current yields. Thus, prior to 2008, a high dividend focused index may have been heavily concentrated in financial services stocks and REITS. Unfortunately, that concentration would have proven disastrous for not only the price value of the index but the cash flow would have been destroyed.

To meet our objectives for stable cash flow in all market environments, the FNRI Index is diversified and holds securities in each market sector. Thus, if and when another financial crisis emerges and one sector is affected more than others by the crisis, the securities outside that sector offer opportunities for continued and growing dividends.

We are willing to sacrifice some current yield for the benefits of income diversification.

As you can see from our FNRI sector holdings, we are currently underweighted in financials simply because not enough financial services companies meet our criteria of having both a meaningful current yield and a high probability of growing that yield. We are actively looking to add securities to that sector, but it may be some time before enough opportunities emerge to significantly increase the weightings of financial services stocks.

The average Price to Earnings Ratio (P/E) for the stocks in the FNRI Index is about 15 as of August 2010.  And our average dividend yield is approximately 5%, with a 5 year historical dividend growth rate of about 10%. These two characteristics are critical to the FNRI Index’s focus on a meaningful current dividend and a meaningful dividend growth rate.

If the current dividend of 3.5% were to grow at 10% a year going forward, then the cash flow on the equities in the portfolio would grow from 3.5% to about 9% on the original cost after 10 years.  And after 20 years, the yield on the cost would be almost 23%.

Now, we don’t anticipate the same dividend growth rate going forward. If we reduce the assumed rate to 6% per year, that still provides a retired investor with cash flow of about 6.3% on their cost after 10 years and almost 11% after 20 years. Given that many retired investors look for a base distribution of 4%, the growing dividend yield would serve as an excellent source of long-term increasing cash flow.

Yield on cost is an important concept for retired investors because they are working with a static pool of investment capital. They won’t be adding to the portfolio going forward. Thus, the retired investor’s yield on cost is critical to their ability to live off the returns of their portfolio.

What’s also unique about the FNRI Index is that it starts with a meaningful dividend yield in today’s markets.  Compare that to a high dividend growth rate but with a small dividend yield of say 0.50%.  If that dividend doubles, the yield is still only 1% of cost; if it doubles again, it is only 2%, and if it doubles again, it is only 4%.  Thus, a high dividend growth rate without a meaningful current dividend yield is not of much use to investors who must live off the cash flow from their portfolios. By the time the dividend reaches any meaningful amount on the investor’s original cost, the investor most likely won’t be around to enjoy it.

 

 

Disclosure: The Farrell-Northstar Retirement Income Index is a list of fixed income and equity securities. The FNRI Index is for informational and educational purposes only. Investors cannot invest in an index and the FNRI Index does not represent an actual security or portfolio. Equity statistics are estimates and were obtained from Ford Equity Research for each individual equity holding in the FNRI Index. Historical dividend payments on the S&P 500 were obtained from Standard & Poor’s. Statistics for the master limited partnerships and energy trusts are excluded from the PE calculation as those securities have different financial structures that need to be analyzed under different valuation metrics. Past performance is no guarantee of future returns. FNRI Index returns have been certified by Standard & Poor's. Consult your individual financial advisor prior to making any financial decisions. Investing involves multiple risks, including but not limited to the permanent loss of capital.