Revamping 60/40 With High Dividend And Low Volatility Stocks

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Includes: AGG, SPHD, SPY
by: Ploutos

Summary

In recent articles, I have shown that shifting the traditional asset allocation mix from 60/40 stocks and bonds to lower-volatility equities produced higher risk-adjusted returns for last 25 years.

In a twist to this approach suggested by a reader, I am substituting Low Volatility/High Dividend stocks for the equity market benchmark.

The proposed low-volatility/high-dividend solution has produced higher returns historically, and may offer investors an appealing alternative given still historically low bond yields.

For investors seeking a smoother long-term investment plan, a 60/40 mix between stocks and bonds has been the long-term asset allocation gold standard. This asset allocation mix has historically sacrificed a little absolute return to generate a less variable return profile than owning equities outright. The negative correlation between stocks and bonds drives this lower variability and has led to a higher risk-adjusted portfolio return.

In a mid-February article, I illustrated that owning low-volatility equities outright produced higher risk-adjusted returns than the traditional 60/40 mix. If blunting equity market volatility is a focus of owning bonds, then low-volatility equities fill some of that gap. I followed that article up by showing that a combination of low-volatility equities and bonds strongly outperformed the traditional stock/bond combination when weighted to achieve the same historical variability of returns of the traditional balanced portfolio. At the behest of a reader, Yawkey5, I am now examining a combination of the S&P 500 High Dividend Low Volatility Index and bonds to the traditional 60/40 portfolio. The S&P 500 High Dividend Low Volatility Index is replicated by a PowerShares fund, the PowerShares S&P 500 High Dividend Low Volatility Portfolio ETF (NYSE:SPHD).

S&P 500 Low Volatility High Dividend Index

While SPHD dates back to only October 2012, data on the underlying index is available back to 1990. The S&P 500 Low Volatility High Dividend Index takes the 75 highest dividend-yielding stocks in the S&P 500, selecting the 50 stocks with the lowest realized volatility over the trailing year. The number of stocks from a given industry is capped at 10. The index constituents are weighted by dividend yield, and rebalancing is done bi-annually in January and July.

Since the advent of the index in 1990, the S&P High Dividend Low Volatility Index has strongly outperformed the S&P 500 with lower return volatility. As depicted below, the index has had an average return of 12.40%, besting the S&P 500 by 270 bps per year through year end.

Source: Standard & Poor's; Bloomberg

This absolute outperformance was achieved with 82% of the return volatility of the S&P 500 as measured by the standard deviation of annual returns. The strategy delivered outperformance in each of the down years for the broad market over this time period. (The returns discussed in this article are total returns, including price appreciation and dividends, with dividends assumed to be reinvested into the respective index.) It makes sense, then, that we could swap out the riskier S&P 500 and a smattering of low-yielding bonds in exchange for this high-dividend/low-volatility fund.

In the table below, I compare the return profile of the S&P 500 (SPY), a bond index (AGG), the 60/40 combination of the two rebalanced quarterly, and the High Dividend Low Volatility Index. Note that 60/40 produces a higher Sharpe ratio than equities or bonds alone. There is merit in the combination for those targeting that risk profile. High-dividend/low-volatility equities are more risky than bonds, but less risky that the S&P 500.

In the last column, I have solved for a portfolio mix between SPHD and AGG that produces the same historical risk profile as the 60/40 portfolio. That mix ends up being 65.2% SPHD and 34.8% bonds. The strategy allows for a larger tilt towards equities, given the lower risk of the high-dividend/low-volatility strategy.

Of course, using historical data to fit a strategy after the fact has obvious data mining issues, but I still believe these figures should be of interest to Seeking Alpha readers. With the U.S. Bond Aggregate yield still in the mid-2% range, tilting some of your bond allocation to high-dividend/low-volatility equities may produce higher risk-adjusted returns. Essentially, we are trading lower-returning bonds and higher-risk equities for higher-dividend/lower-volatility equities, which generated higher absolute returns over this data period. The current yield on SPHD of around 3.7% certainly looks attractive to traditional fixed income.

Over this quarter-century period, $1 invested in the traditional 60/40 mix at the beginning of 1991 would be worth $8.72 at the end of 2016. Conversely, $1 invested in the 65/35 High Dividend/Low Volatility stock/bond mix, which we have shown had the same low level of variability as the 60/40 mix, would be worth $14.59 - a figure roughly 67% greater than with the 60/40 mix. Readers will likely point out that 60/40 stock/bond outperformed through 2000, as the grey line in the graph exceeded the purple line. This outperformance was driven by the tech bubble, as those stocks were held in the broad index, but appeared less frequently in the High Dividend/Low Volatility portfolio.

The traditional 60/40 bond/stock mix has been a central tenet of portfolio management for many investors. Over the last 25 years, a tilt towards high-dividend/low-volatility stocks and away from the broad stock gauge and bonds would have generated a cumulative 67% higher return with the same level of risk. The traditional disclaimers that historical results may not be replicated in the future still certainly apply, but this research should be welcome food for thought for Seeking Alpha readers.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore, inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance and investment horizon.

Disclosure: I am/we are long SPHD, SPY.

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.