Tony Ash's  Instablog

The capital markets are still tough to navigate in the post-Crisis environment. Low rates, high volatility, and increased risk for "black swan" events (e.g., Eurozone, China, Middle East, etc.) all combine to make this a tough environment to plan for long term investment returns.

After much study and deliberation, I have come to the conclusion that the current market focus for Dividend Growth Strategies is well founded and is the best place to position core holdings. It should be supplemented with small cap equity, emerging market, and global bond positions. The actual mix is dependent upon whether you are funding college, retirement, or estate planning for heirs.

Why is a Dividend growth strategy the best place to be right now? Following are my top 10 reasons:

1. Dividend yields are high relative to bonds

2. Payout ratios are low

3. Corporate balance sheets are heavy with cash

4. Corporate focus for dividend-payers is targeted to support dividends

5. Best dividend-payers are weighted in less volatile sectors of utilities, consumer defensive, and industrials; currently under-weighted to financials pending recovery

6. Businesses have adapted to become more efficient post-Crisis and better positioned for more profitable business to support dividends

7. Low beta compared to broad market index

8. Simple to understand and easy to filter

9. Yield component available to reinvest or spend

10. Price component is relatively less volatile

What is the best way to play this strategy? I think the DVY ETF based on Dow Jones U.S. Select Dividend Index is easy to understand and is a reasonable filter. It is not too narrow and takes a bit more risk than other Dividend Growth ETFs like VIG. Stocks included in the index need to have paid increasing dividends over the last 5 years, have a 5-year average payout ratio less that 60%, paid dividends in each of the last five years, and have daily trading volume of 200,000 shares in ensure liquidity.

Following are the key metrics that support a strong case for DVY:

Expense ratio: 0.40%

Dividend Yield: 3.51%

Beta: 0.58

Standard Dev: 12.70%

3-yr Sharpe Ratio: 1.74

Commissions: Free if traded through Fidelity

Why not a Dividend Growth strategy? It most likely will underperform other more risky asset classes like small cap and emerging markets on a total return basis, but still provide good risk-adjusted return. Exposure to other asset classes is needed to optimize the long-term total portfolio total return.

Disclosure: I am long DVY.

Hard to ignore the notable headlines over the past month or so as many major insurers begin to telegraph how they plan to adapt to the "new reality" of very low rates, high capital market volatility, and increased regulatory/rating agency pressure.

The Met came out at their Investor Day and said in no uncertain terms that they would exit businesses that did not meet their ROE benchmarks.  Sun Life put their money where their mouth was and actually pulled the plug on all new VA and life insurance in the U.S. (after exiting FA earlier in the year)!   ING and John Hancock likewise have exited VA businesses.  A fuller survey of the industry would show more instances of these kind of actions, I am sure.

What is all this telling us?  Obviously, one way to deal with the very difficult external environment is to not play in it!  This should provide a better playing field for those companies left who are willing to wait it out!  Re-pricing insurance products (i.e., lower guaranteed rates, etc) should make it easier for investment departments to produce target returns without stretching with added risk. 

The cost of all those product "guarantees" may finally be allowed to be fairly priced and passed on to the financial product consumer.  Consequently, waiting it out may make sense for the remaining insurance players to earn above target ROEs.  

On the flip side, financial product consumers better get used to the "new reality" and start saving more for retirement because "fairly priced" long term guarantees (if you can find them!) mean lower net returns.