We have made it no secret that we think equity returns from here forward are likely to be significantly muted. The risks in today's equity market, we believe, are skewed heavily to the downside with yield-seekers especially susceptible to a drawdown. While a "dividend bubble" may not be the correct characterization of the current environment, we do believe that asset-flight risks are elevated in the higher-yielding, lower-beta equity names.
Investors appear to be flocking into those stocks, either directly or via ETFs. The huge demand has raised a substantial amount of assets for the ETF creators in these dividend-focused strategies. Billions have been flowing into these products under the belief that returns of the near past will continue. These investments are heavily skewed towards utilities and consumer staples, the valuations of which, are sky-high.
The performance of these low-vol and dividend-paying funds since the start of the year is clearly being driven by a flock to safety. Investors worried that higher interest rates signaled by the Fed late last year would impair these stocks. However, rates have fallen significantly since the Fed conducted their one and only hike in the cycle (thus far). It remains to be seen whether or not they continue to raise rates at all and the markets are currently pricing in little to now . This has led to a significant amount of demand for these products seeking yield in a yield-less world.
Following the Brexit vote, the chance of a rate CUT is now larger than a hike through 2016.
With $12T in global sovereign debt now yielding a negative interest rate as well as corporate bonds starting the same trend, foreign investors are piling into these dividend-focused products as well. In one of the more popular of these products, the iShares MSCI USA Minimum Volatility ETF (NYSEARCA:USMV), which has $13 billion in assets, approximately 40% of those funds flowed in just this year. The ttm P/E ratio (not forward!) is a sky-high 24.8x compared to the market as a whole trading at 18.7x.
Performance chasing is now in full force as noted by a recent Bloomberg piece.
Instead, the billions of dollars flowing into ETFs that track stocks exhibiting the least amount of volatility is a classic case of performance-chasing. Like little kids playing soccer, many investors follow the outperformance ball, so to speak, wherever it goes. It happens with stocks, bonds, active mutual funds, hedge funds, and increasingly with ETFs. Right now, the soccer ball is in the low-volatility part of the field, where nearly all low-vol ETFs are outperforming their respective markets-be they large-caps, small-caps, or international equities.
Chris Brightman, CIO at Research Affiliates, has noted that the money flow has boosted the underlying dividend and low-volatility stocks to a valuation premium that is "too high to invest." While these stocks typically trade at a premium to the market, regressing them to a mean P/E valuation equates with negative realized returns over the next several years. The underlying momentum of these stocks likely means that during periods of excessive volatility these low-volatility stocks will be inherently volatile given the overvalued states that they currently trade.
Clearly investors are all herding in the same direction and that typically doesn't end well. Real estate was deemed to be a safe bet in the run-up to the financial crisis similar to the way dividends and low-volatility are today. We think investors need to be cognizant of the potential risks in their portfolio and would caveat that by saying drawdown risks using historical returns is likely understating that risk.
The Variation of Expected Returns
The forecasting of future returns can be a fool's errand given the variability of returns in a given year. The sequence of returns risk (good summary from MFS) is likely to bite a lot of these dividend investors in the behind as many advisors or savers at or near retirement use a standard rate of return, for example 6% per year. That constancy of returns opens up investors to falling short in their financial plans, especially during retirement years when they are making distributions from their portfolios.
In an interesting piece by Wade Pfau at Retirement Researcher, Dr. Pfau stated that you can't control when you're born. He asserted that sequence of returns risk is derived from the investment strategy chosen, not from the market. The number of paths that a portfolio can take in ten years is actually ten-factorial or 3.63 million different scenarios.
While the sequence of returns during the accumulation phase does affect your ending portfolio values, it is primarily during the retirement phase where the effect can be devastating. A retiree withdrawing during their early years at the same time their portfolios fall in value versus in later years will be in a significantly different position than if the market is rising earlier on and falling later. In my thesis, the number of years has to be longer than five years for the effect to be tangible, and ten years for it to be significant.
Our conclusion is simple. Investors should demand a larger risk premium to own equities versus bonds under various market environments. And that risk premium should vary based on the current market conditions and other market variables. An investor in bonds does this based on their forecast for interest rates and the current bond yields- and thus their effects on total returns. Current conditions in the equity markets do not adequately incorporate the fundamentals and are likely Fed liquidity-driven.
Using Closed-End Funds For Retirement Income
While we think investors are understating the risks in higher-yielding and low-volatility stocks, they may also be overstating the risks in fixed-income closed-end funds (CEFs). Investors tend to look at the volatility of the prices of CEFS and infer that these are the risks inherent in the securities. But remember, the volatility in the prices of CEFs are driven by supply and demand of mainly retail investors- not institutional players who deem the space too small.
If an investor wants to identify the true risk of the CEF, they should be looking at the volatility (standard deviation) of the NAV, not price. Standard deviation of CEF NAVs typically run between 35% and 60% less than the volatility of their prices. We tend to look at the much higher volatility in price as an opportunity, not a negative factor.
Using Warren Buffett's Mr. Market analogy, the volatility in the price of a CEF gives an investor a price at which it will buy and sell on a given day. Mr. Market may offer the assets at a price which is a discount or a premium, depending on the sentiment at the time. We believe this gives the patient investor an opportunity to either buy or sell a typical basket of securities opportunistically.
CEFs are fairly unique in that their pools of capital are fixed and the portfolio managers are unfazed by the flow of funds. In other words, a portfolio manager of a closed-end fund never has to liquidate a position at the most inopportune time. It also allows them to invest in small, less liquid investments knowing they never have to sell if they aren't forced. Another key factor is their ability to lever, up to 50% of the funds capital base. This allows them to add new positions without having to sell old ones to raise cash. It also allows them to borrow cheaply, typically below Fed funds rates, and reinvest in yields above 3%-4%, earning the spread.
This leveraging is usually held out as being too risky for some income investors. But these same people are often willing to invest in Johnson and Johnson (NYSE:JNJ), Coca-Cola (NYSE:KO), or even mREITs with much higher leverage. Johnson and Johnson, for example, has financial leverage of 1.88 meaning its effectively levered by 88%. Much more than any closed-end fund. Coke has financial leverage of 3.66 with annualized volatility in price of 17%. And yet investors are willing to pay 22x, experience standard deviations of 17%, just to get what Coke pays out in dividend yield, just 3.1%.
The prices of the average multi-sector bond CEF have annualized price volatility of 11.3% but has an average total yield of 8.3%. We think the comparison makes a very compelling case for CEF investing for income rather than increased dividend allocations, especially for people living off the cash flows.
Acquiring high-quality CEFs through thorough analysis will be a focus of ours in the coming weeks and months. The dislocations that can occur will provide solid entry points for investors. Accumulating these high-yielding CEFs at solid discounts to NAV while being aware of coverage ratios, leverage, and underlying quality can provide a much safer, steadier, and large income stream for retirement.
We provide some of our best ideas below but for real-time analysis and trade ideas, please consider our marketplace service.
|Name||Ticker||$ Current |
|Discount/ Premium To NAV|
|PIMCO Dynamic Income||PDI||27.11||15.36||2.61%|
|Western Asset Mortgage Defined Opp||DMO||23.51||10.93||10.47%|
|PIMCO Income Opportunity||PKO||22.59||9.89||2.05%|
|DoubleLine Income Solutions||DSL||18.07||9.42||-6.05%|
|PIMCO Corporate & Income Opps||PTY||13.99||12.29||8.59%|
|PIMCO Dynamic Credit Income||PCI||18.68||10.67||-7.03%|
|BlackRock Income Trust||BKT||6.62||4.09||-5.60%|
|BlackRock Multi-Sector Income||BIT||16.3||8.13||-9.54%|
|Nuveen Enhanced AMT-Free Muni Credit Opp||NVG||16.22||4.66||-7.36%|
|BlackRock MuniYield Qty III||MYI||15.64||5.81||-0.26%|
|BlackRock Credit Allocation Inc||BTZ||12.85||6.71||-9.94%|
|Pacholder High Yield||PHF||7.02||8.55||-7.87%|
Disclosure: I am/we are long PDI, PCI, DMO, NVG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.