By John L. Jacobs, NASDAQ OMX Global Indexes
Searching for yield in unlikely places has been an effective strategy for investors looking to gain exposure outside of the classic reliable income sectors such as utilities, healthcare or consumer staples. Social needs have a way of shaping investor demand; and as the ever-burgeoning population of retirees shifts from a growth mentality to an income philosophy, there are several innovative products that could very well shape the future of dividend investing.
This year, investors were broadsided by rising interest rates. Principal values of most fixed-income assets have exhibited volatility that we have not seen for decades. And while dividend-paying stocks briefly weakened, they are now back to all-time highs. With earnings multiples on commonly held dividend stocks now stretched to historically high levels, where are investors turning to satisfy their cash-flow needs while steering clear from inevitable bull traps?
When looking at an investment opportunity to generate an income stream, investors should ask themselves whether that investment can maintain its principle value alongside the ability to grow its distributions over time. In addition, performing due diligence on the level of volatility the investment has exhibited throughout history will offer a glimpse of what to expect in the event the economy takes a down turn.
Dividend Growth Over Time
Dividends have accounted for over 40% of total returns over the last 80 years1. And it has been shown that companies that grow their dividends over time will weather a rising rate environment, and can even thrive in its wake. A great example of this would be to compare the current 10-year Treasury note yield to the yield on a basket of dividend growth stocks.
This year we saw a tremendous rise in the 10-year Treasury note yield, which moved from a low of 1.6% to its current level of 2.5%. During that same time frame, the WisdomTree U.S. Dividend Growth Index (DGRW), a broadly diversified basket of dividend growth stocks, has maintained its yield of 2.00%.
If an investor can reasonably say that a basket of stocks will aggressively grow their dividends year-over-year for the next 10 years, the chances of maintaining purchasing power due to inflation are greatly enhanced. In addition, now is still a great time to invest in dividend growth stocks since payout ratios (or the percentage of free cash flow that is returned to investors) are still very attractive when compared to forward earnings momentum.
Investors seeking a higher yield may consider the PowerShares High Yield Equity Dividend Achievers Portfolio (PEY), which is comprised of 50 stocks selected principally on the basis of dividend yield and consistent growth in dividends. The current 30-day SEC yield on PEY is 3.53% and it has a larger emphasis on small and mid-cap dividend paying stocks. Since there are many ways of calculating yield, the 30-day SEC yield is a method specified by the SEC to calculate yield on funds, which then must be posted by the fund provider to create an “apples to apple” figure for investors. PEY is overweight small and mid-cap stocks vis-à-vis a more natural / neutral market-cap weight.
Sector Dividend Investing
A more targeted theme investors might consider when trying to grow income over time would be an allocation to a specific sector, such as large-cap value technology stocks. The First Trust NASDAQ Technology Dividend Index Fund (TDIV) is designed to include companies that are consistently paying and/or growing their dividends over time. Many of these companies are currently trading at price/earnings multiples marginally smaller than the general market. The current 30-day SEC yield of 2.90% from the 87 holdings in TDIV is more attractive when juxtaposed with DGRW’s more broadly diversified mix of 294 holdings.
With the majority of TDIV’s allocations outside interest-rate-sensitive equity themes, its constituents aren’t as dependent on debt issuance as other income sectors. Investors may ultimately be better positioned to endure a rise in long-term interest rates, without borrowing costs eating into profitability.
Often times sector investing can enhance returns by providing overweight allocation to a segment of the market that offers attractive growth and income potential. To do this, investors would choose an index that maintains exposure to companies that are actively increasing their returns to shareholders.
Dividend Investing Through Multiple Asset Classes
Targeted sector strategies aside, a multi-asset approach is another way for investors to gain exposure to a broadly diversified and liquid basket of income producers. Their popularity is just beginning to gain momentum, with individual and institutional investors seeking a low-cost alternative to traditional balanced mutual fund strategies.
Breaking the mold of traditional asset allocation, the First Trust Multi-Asset Diversified Income Fund (MDIV) embodies a colorful mix of income-producing assets that offers an attractive yield and opportunity for growth of invested capital. Its asset allocation framework is designed around five core sleeves, which are currently allocated to: 25% dividend equities, 15% high yield bonds, 20% master limited partnerships, 20% preferred stocks and 20% REITs. With a 30-day SEC yield of 6.85%, this ETF is allocated to some of the highest dividend paying sectors of the market.
The inherent feature that is most important to this type of multi-asset strategy has to be its performance in a bifurcated market environment. As one asset class can often become extended or even overvalued, owning a diversified mix can prove to be a pragmatic risk management tool in a volatile market.
And yet another ETF in this category is the Guggenheim Multi-Asset Income ETF (CVY), which incorporates closed-end funds and an overweight allocation to dividend-paying equities in its mix.
Part of any successful portfolio management approach is the abundance of choices available to reach a stated goal. The more tools an investor possesses, the higher the probability their goal will ultimately be achieved. Although the basic philosophy of dividend investing will always remain the same, the emergence of innovative strategies presents investors with robust value propositions in virtually any market environment.
1 Source: Ibbotson, as of December 31, 2010.
NASDAQ® is a registered trademark of The NASDAQ OMX Group, Inc. (which collectively with its affiliates is referred to as “NASDAQ OMX”) and is licensed for use by WisdomTree U.S. Dividend Growth Index (DGRW), PowerShares High Yield Equity Dividend Achievers Portfolio (PEY), First Trust Multi-Asset Diversified Income Fund (MDIV), First Trust NASDAQ Technology Dividend Index Fund (TDIV), Guggenheim Multi-Asset Income ETF (CVY). DGRW, PEY, TDIV, MDIV and CVY have not been passed on by NASDAQ OMX as to its legality or suitability, and it is not issued or sold by NASDAQ OMX. NASDAQ OMX makes no warranties and bears no liability with respect to the DGRW, PEY, TDIV, MDIV and CVY.
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This article was originally published on Dec. 4, 2013 on Forbes.com.