Reinvigorating income with equities

Nov 26th, 2020 | By | Category: Equities

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By Holly Framsted, US Head of Factor ETFs at BlackRock.

Holly Framsted, Head of US Factor ETFs within BlackRock’s ETF and Index Investment Group.

Holly Framsted, US Head of Factor ETFs at BlackRock.

Investing for regular income seems like it should be a straightforward proposition. And yet, there is more to income investing than many appreciate.

Income investment strategies come in all different shapes and sizes, including stocks, bonds, bond-like stocks, and stock-like bonds. And the effectiveness of each strategy at delivering income can vary with market conditions.

One of the most well-known income-producing assets is the 10-year US government bond. In October of 1987, this asset boasted a yield over 10%. By 2007 the yield had reached 5%, a function of rising after reaching lows during the early 2000’s recession. This year, its yield hit a record low near 0.5%.

The current outlook for tepid economic growth and recent comments from Federal Reserve Chairman Jerome Powell indicate low rates may be here to stay (though an effective COVID-19 vaccine soon may affect this view). In this environment, clients I speak with are looking for ways to reinvigorate the traditional approach to seeking income.

Source: BlackRock.

The dividend approach to seeking income

Equity dividends may offer a higher yield in this historically low-rate environment. A potential advantage of the dividend approach vis-à-vis bonds is that, besides current income, equities may also grow their dividends and realize capital appreciation over time. The combination can help deliver returns that keep pace with or exceed inflation. While inflation has been subdued in recent years, the BlackRock Investment Institute (BII) recently forecasted higher inflation in the medium term, meaning that the inflation-adjusted real yield for investors could be even lower.

Notably, investors who utilize a 60/40 portfolio may already be exposed to equities as a source of income. As the chart below shows, equity dividends may comprise a greater portion of a 60/40 portfolio as bond yields have fallen.

Source: BlackRock.

Equity income tools are sharper than ever before

In 2020, income investors face a different landscape than in decades past. As the markets have evolved, so too have the index-based solutions which now offer direct and thoughtful exposure to equity income. For example, the Morningstar Dividend Yield Focus Index explicitly seeks exposure to US companies with high dividend yield, while also screening for dividend sustainability and other elements of quality. This index posts a dividend yield of 5.0% while the Russell 1000 Value and S&P 500 offer yields of 2.7% and 1.8% respectively, as of the end of October.

Dividend-growth strategies are another way to think about equity income. Dividend-growth indexes such as the Morningstar US Dividend Growth Index provide access to companies that have consistently grown their dividends for five years or longer and have the financial means to continue to do so. While its methodology does not explicitly seek to maximize yield, it has captured an above-market dividend yield of 2.9% by including only dividend-growing companies.

FEATURED ETFS

iShares Core High Dividend ETF (HDV US)

– Tracks the Morningstar Dividend Yield Focus Index
providing access to 75 dividend-paying domestic
stocks that have been screened for financial health.

– Houses $5.6bn AUM; expense ratio of 0.08%.

iShares Global Infrastructure UCITS ETF (INFR)

– Tracks the Morningstar US Dividend Growth Index
providing exposure US companies that have a
history of sustained dividend growth and
that are broadly diversified across industries.

– Houses $13.5bn AUM; expense ratio of 0.08%.

Quality matters when thinking dividends

Notably, both high-yield and dividend-growth indexes discussed above incorporate “quality” screens. Since yield is a function of dividend payments divided by price (D/P), higher-yielding stocks may not always represent companies with durable business models that can support the distribution of high current income to investors. Occasionally a stock’s high yield can signal a “yield trap,” meaning that the yield is high mostly because its stock price had fallen sharply. Quality screens in indexes can help minimize exposure to the risks of yield traps.

Investors may also consider managing risk with income strategies at the portfolio level. This can be done with complementary fund holdings. For example, a quality factor strategy may be a good complement to an income-focused investment because it counterbalances risk related to stocks that might have a high yield but weaker fundamentals. Consider as a representation of quality the MSCI USA Sector Neutral Quality Index, which focuses on finding companies with high profitability and strong balance sheets. The below chart shows dividend yields and return on equity (ROE) as a simple proxy for quality. Both high-yield and dividend-growth strategies show a more favorable trade-off between yield and quality than the Russell 1000 Value Index. While the dedicated quality index does not explicitly seek higher yield, its significantly higher ROE versus both the Russell 1000 Value Index, but more importantly the S&P 500, demonstrates the benefits quality screens can provide at the portfolio level to income-seeking investors.

Source: BlackRock.

Equity income may be the missing portfolio link

Stocks with high dividend yields may look different from stocks with high dividend growth rates; however, both are potentially useful to income investors. High-dividend strategies tend to be concentrated in more mature sectors, fall predominantly in the large-value “style box,” and can exhibit higher interest rate sensitivity. In contrast, dividend-growth strategies typically capture a mix of mature and growth-oriented sectors, hold a blend of both value and growth-oriented securities, and exhibit less interest rate sensitivity than high yield focused strategies. These very different approaches to the equity income segment of the market generate only 30% exposure overlap, allowing them to be used together inside portfolios. In a low-rate world, dividend equity strategies may be the missing link to provide investors with the income they are no longer getting from bonds, while still offering equity market exposure to provide upside in an inflationary environment.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

DISCLOSURES

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses, which may be obtained by visiting the iShares Fund and BlackRock Fund prospectus pages. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

There is no guarantee that dividends will be paid.

There can be no assurance that performance will be enhanced or risk will be reduced for funds that seek to provide exposure to certain quantitative investment characteristics (“factors”). Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. In such circumstances, a fund may seek to maintain exposure to the targeted investment factors and not adjust to target different factors, which could result in losses.

Index performance is for illustrative purposes only.  Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

This material represents an assessment of the market environment as of the date indicated; is subject to change; and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any issuer or security in particular.

The strategies discussed are strictly for illustrative and educational purposes and are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. There is no guarantee that any strategies discussed will be effective.

The information presented does not take into consideration commissions, tax implications, or other transactions costs, which may significantly affect the economic consequences of a given strategy or investment decision.

This material contains general information only and does not take into account an individual’s financial circumstances. This information should not be relied upon as a primary basis for an investment decision. Rather, an assessment should be made as to whether the information is appropriate in individual circumstances and consideration should be given to talking to a financial professional before making an investment decision.

The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).

The iShares Funds are not sponsored, endorsed, issued, sold or promoted by Barclays, Bloomberg Finance L.P., BlackRock Index Services, LLC, Cohen & Steers Capital Management, Inc., European Public Real Estate Association (“EPRA® ”), FTSE International Limited (“FTSE”), ICE Data Services, LLC, India Index Services & Products Limited, JPMorgan Chase & Co., Japan Exchange Group, MSCI Inc., Markit Indices Limited, Morningstar, Inc., The NASDAQ OMX Group, Inc., National Association of Real Estate Investment Trusts (“NAREIT”), New York Stock Exchange, Inc., Russell or S&P Dow Jones Indices LLC. None of these companies make any representation regarding the advisability of investing in the Funds. With the exception of BlackRock Index Services, LLC, who is an affiliate, BlackRock Investments, LLC is not affiliated with the companies listed above.

Neither FTSE nor NAREIT makes any warranty regarding the FTSE NAREIT Equity REITS Index, FTSE NAREIT All Residential Capped Index or FTSE NAREIT All Mortgage Capped Index; all rights vest in NAREIT. Neither FTSE nor NAREIT makes any warranty regarding the FTSE EPRA/NAREIT Developed Real Estate ex-U.S. Index or FTSE EPRA/NAREIT Global REIT Index; all rights vest in FTSE, NAREIT and EPRA.“FTSE®” is a trademark of London Stock Exchange Group companies and is used by FTSE under license.

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