Equity income products are more popular than ever and have attracted significant assets in recent years. The reason for this is twofold: first, fixed income assets that have traditionally been thought of as the income-generating component of a portfolio have been unable to fulfill their role in today’s low interest rate environment and, second, equity products that have traditionally been the growth component of a portfolio have been underperforming dividend-oriented strategies. This double whammy has resulted in the proliferation of equity income products that investors are chasing in the hope of satisfying both their income and capital appreciation needs.
As investors reach for yield in equities, at valuations that are above historical averages, they should keep in mind that the main objective of an equity income product is to generate income. While in the long run it is true that equity income assets will generate significant returns in the form of dividend payments, capital appreciation assets should outperform on a total return basis. This point is illustrated in Figure 1 which uses the Dow Jones US Select Dividend Index as a measure of the equity income opportunity set.
Figure 1. Barron’s 400 Performance Comparisons Ending July 2016
| Annualized | Cumulative | ||||||
| DJ US Select Dividend | Barron’s 400 | Russell 3k | DJ US Select Dividend | Barron’s 400 | Russell 3k | ||
| 1-Year | 18.4% | -1.4% | 4.4% | 18.4% | -1.4% | 4.4% | |
| 3-Years | 12.8% | 8.0% | 10.6% | 43.7% | 26.0% | 35.4% | |
| 5-Years | 15.4% | 11.3% | 13.0% | 104.7% | 71.0% | 84.2% | |
| 10-Years | 7.4% | 8.5% | 7.8% | 104.5% | 125.5% | 112.4% | |
| Since 12/31/1997 | 8.8% | 10.8% | 6.6% | 379.5% | 576.4% | 229.1% | |
* Ending July 2016. Sources: MarketGrader Research & FactSet. Performance is shown as total returns. 12/31/1997 is the base date of the Barron’s 400.
To be sure, equity income products have outperformed most other equity strategies in recent years, which partly explains their popularity. For example, the DJ US Select Dividend Index has outperformed both the Barron’s 400 (B400) and the broad equity benchmark (Russell 3K) on a one-, three- and five-year basis.
Over a longer 10-year period, though, or since the start of 1998 (a period 19 years and seven months), the capital appreciation-oriented B400 has been the top performer in our small sample. For instance, over the entire period, the B400 has outperformed the income index by about 2% on an annualized basis, which translates into a little less than 200% on a cumulative basis since its base date. Note that over this period the Dow Jones US Select Dividend index also outperformed the broad equity benchmark. Furthermore, the capital appreciation benchmark (B400) outperformed both the income index and the total market benchmark by a wide margin from the March 2009 bottom to the broad market top last summer, as illustrated in Figure 2, a time during which you would expect it to do so (with the benefit of hindsight, of course).
Figure 2. Cumulative Total Return for Select Indexes, March 2009 – June 2015
Source: Bloomberg.
With this interplay between capital appreciation and income in mind, many would argue for an investment approach called “market timing” that tries to time the move into and move out of outperforming and underperforming assets, respectively. Most serious professional money managers, though, would not suggest using a market-timing strategy to enhance returns but would, instead, employ a diversified asset allocation approach allowing them to participate in the upside (of an outperforming asset) and at the same time hedge the downside (of an underperforming asset) with the understanding that foresight, unlike hindsight, is imperfect. More importantly, this allows them to participate fully in the market while smoothing out returns.
Figure 3 presents the performance of exactly such an investment strategy. In its simplest form, the strategy does not engage in guessing games of which index – income or capital appreciation – is going to outperform. Instead, the strategy calls for allocating assets to both indexes in a predefined proportion (called the policy allocations). The policy allocations to the two assets of course depend on both the investors’ objective (income or growth) and their risk tolerance.
Figure 3. Figure 3. Using the Barron’s 400 Within An Income + Growth Portfolio
Sources: MarketGrader Research & FactSet. Performance is shown as total returns. The diversified portfolio is rebalanced at the beginning of each calendar year.
In Figure 3 we illustrate the performance of 50/50 diversified mix of the Dow Jones Select Dividend Index and the Barron’s 400 Index that is rebalanced to the 50/50 policy weights at the start of each calendar year. Keep in mind that the rebalancing is critical to the implementation of the strategy. The rebalancing essentially allows the investor to sell the outperforming, more expensive asset, thereby, cashing in the gains and using them to buy the underperforming, or cheaper asset. So, for the DJ US Select Dividend and the B400 mix, in the earlier years when the B400 was outperforming, the portfolio was partaking in that upside, all the while investing in the underperforming, albeit cheaper, income-oriented asset. Similarly, in the more recent years, when the DJ US Select Dividend index was doing well, the portfolio was again partaking in that upside (since the portfolio was invested in that asset all along), meanwhile still investing in the underperforming, albeit cheaper, capital appreciation asset. In the future when the cycle reverses, the portfolio will be holding the capital appreciation asset and can partake in the upside. As always, the question is when will the cycle reverse? The answer is: it is impossible to say.
The benefits of such an approach are self-evident from Figure 3. Figure 4 provides some more performance comparisons over the short-, medium- and long-run.
Figure 4. Barron’s 400 + Income Diversified Mix: Performance Comparisons Ending July 2016
| Annualized | Cumulative | ||||||||
| DJ US Select Dividend (A) | Barron’s 400 (B) | Diversified Mix = 0.5A + 0.5B | Russell 3k | DJ US Select Dividend (A) | Barron’s 400 (B) | Diversified Mix = 0.5A + 0.5B | Russell 3k | ||
| 1-Year | 18.4% | -1.4% | 8.1% | 4.4% | 18.4% | -1.4% | 8.1% | 4.4% | |
| 3-Years | 12.8% | 8.0% | 10.5% | 10.6% | 43.7% | 26.0% | 34.9% | 35.4% | |
| 5-Years | 15.4% | 11.3% | 13.5% | 13.0% | 104.7% | 71.0% | 88.0% | 84.2% | |
| 10-Years | 7.4% | 8.5% | 8.1% | 7.8% | 104.5% | 125.5% | 118.2% | 112.4% | |
| Since 12/31/1997 | 8.8% | 10.8% | 10.0% | 6.6% | 379.5% | 576.4% | 487.5% | 229.1% | |
* Ending July 2016. Sources: MarketGrader Research & FactSet. Performance is shown as total returns. 12/31/1997 is the base date of the Barron’s 400.
Note how the diversified mix, both in the short and long run, does relatively well. In fact, over all time-periods it outperforms the broad equity benchmark (Russell 3K). In addition, over the entire time period starting in 1998, the 50/50 Diversified Mix results in a cumulative return of 487.5%, which, even though is not as large as the cumulative return of the capital appreciation asset (B400) which generated a return of 576.4%, it is still very attractive. On an annualized basis, the 50/50 Diversified Mix across the two assets results in a total of 10%, versus the 10.8% return of the B400. One could argue that the forgone return of 80 basis points is a small price to pay for not having to time the market and for smoothening out returns over both the short and long-run. It would not be a stretch to say that most market timing strategies will underperform the Diversified Mix. If there is market timing strategy that outperforms the Diversified Mix, it is most likely because the buy and sell call got lucky.
The diversified mix not only removes the guesswork out of selecting the “winning” asset, but as mentioned earlier, it also smoothens returns (lessens volatility). This is because the two assets in the mix, even though both are equity assets, are not perfectly correlated. Figure 5 present the 36-month rolling correlations between the Dow Jones US Select Dividend index and the Barron’s 400. Notice how the correlations decline when diversification is needed the most – in bear markets!
Figure 5. Barron’s 400 – Total Return Correlations
Sources: MarketGrader Research & FactSet. Correlations use monthly total returns.
