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Portfolios

Niche Funds for Yield Seekers

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

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,

Unlike the other options mentioned here,

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

For those willing to accept the risks the sector carries,

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

Two closed-end funds focused on energy MLPs receive Morningstar Analyst Ratings of Bronze,

Utilities 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,

Among ETFs,

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