Equity Income: A Worthy Alternative
With Treasury yields basically at zero, fixed income isn’t a reliable source of sufficient yield today. And what yield there is involves straying into the riskier segments of that market. The lack of yield combined with the growth-driven equity market rally of the last five years may have some investors questioning the benefits of an income-focused portfolio. But we believe that a well-balanced equity income portfolio is a worthy alternative for income-focused investors. Our analysis indicates that these investors typically fare better with this approach than selling to meet their income requirements. Notably, the benefits tend to become more pronounced when equity markets are less favorable.
Properties of a Well-Balanced Equity Income Portfolio
A risk to equity income portfolios is that they can be concentrated in higher-yielding sectors such as Utilities, Energy and Real Estate, and certain high-yielding industries like Mortgage REITs and Telecommunications. So, during the portfolio construction process, it’s important to round out sector exposures—even if it reduces the overall yield potential of the portfolio.
Diversification goes beyond sector and industry exposure, though. It also relates to the sources of income in the portfolio. We think about income in five separate segments for the Equity Income model portfolio that we manage at Global X: High Dividend Yield, Core Dividend and Dividend Growth, Preferreds, Covered Calls, and Sector Specific. Each of these segments has its own specific purpose in the portfolio.
A New Decade for Income Investing
The growth rally that dominated the recovery since the Global Financial Crisis altered the way that income-focused products performed relative to the broader market. Over the last decade, especially the last five years, investors generally fared better investing in the broad market and selling to meet their income requirements. However, for this strategy to remain successful, the status quo from the last decade would need to continue. In this uncertain environment, that’s a risky strategy.
For example, looking at the Cboe NASDAQ-100 BuyWrite Index (Covered Call Index) since its inception, its cumulative total return was similar to that of the S&P 500 Index until mid-2012. Two factors contributed to this relationship breaking down: the length of the recent bull market and the shift to a lower volatility environment. Of course, COVID-19 brought both of these catalysts to an end.
Chart 1 shows that up until mid-2012, rolling five-year total returns were reasonably muted for the S&P 500 Index. Comparing Charts 1 and 2, the S&P 500 performed better than the Covered Call Index when the S&P 500’s five-year rolling average total return has been improving, notably from 2006 to 2008 and since mid-2012.
During the financial crisis, companies with high dividends typically performed better than the overall market. Small-cap value also held up reasonably well. However, the U.S. equity market became much more growth- and large-cap oriented starting in 2014. In the six years since then, both large caps and growth were dominant for four of those years, while just large caps led in another year. With COVID-19 dynamics increasing the discrepancy between growth and value, and between large and small-caps, the trend of large caps and growth leading performance continues in 2020.
Conclusion: The Future Remains Unknown
The big consideration for an investor is if they require a specific amount of monthly income from their portfolio. If so, the question becomes, are they better off investing in a product that tracks an index such as the S&P 500 and selling a set amount per month or by using an income-focused portfolio? The answer depends greatly on the investor’s starting point, their endpoint and how markets perform in between. Investors typically don’t appreciate that type of gamble with their livelihoods.
If the strong growth-oriented rally continues, driven by the potential longer-term effects of COVID-19 and increased adoption of technology, the broad market may provide higher total returns than an income focused solution. But this is the riskier option because of the potential for the S&P 500 Index to decline or have a period of reasonably flat returns. If these risks were to materialize, the more income-focused strategy would likely be a more suitable approach for an investor with a need for income.