November 1, 2011
Two reference portfolios
To provide context for the yield vs. risk results, I calculated the yield and risk for two model portfolios that I developed in earlier articles, based on current prices:
The current yield and projected risk for each of these portfolios is shown on the graph of risk vs. yield above. The Ultimate income portfolio (UIP) is not on the efficient frontier. The yield shown for the UIP does not include the income derived from covered calls sold against the portfolio holdings, which would provide an additional 2.6% in annualized return. With that additional income, the UIP would be above the efficient frontier. A more apples-to-apples comparison is with the low risk/high income portfolio, which I designed to maximize traditional sources of yield (e.g. without call options). This portfolio sits very close to the efficient frontier.
A range of portfolios should provide similar yield and risk, and the consistency of the maximum yield-to-risk relationship between these two reference portfolios and my analysis of European stocks confirms the validity of this methodology. In another test, I calculated the optimal yield portfolios including and excluding FTE from the set of possible investments. Even though FTE looks uniquely attractive on a standalone basis, there is almost no difference between the optimal portfolios with and without FTE.
European stocks now offer high yields and are naturally attractive for income-oriented investors. Indeed, I have assembled a set of 18 well-known firms with an average yield of 6.4%, about three times the yield of the S&P 500.
But they do not provide a well-justified play for income investors in the U.S.
Aside from FTE, TEF, and NGG, the range of European stocks analyzed here have very high risk relative to their yields. FTE and TEF are very attractive, however. Most of these European firms are not providing sufficient yield to justify their risks for income investors. On the basis of increased portfolio diversification, some of the riskier stocks (such as STD and NOK) have marginal value, but these stocks are extremely risky when viewed on a standalone basis.
My results explain, and are consistent with, the performance of international dividend-oriented funds such as the Wisdom Tree International Dividend Fund (DOO). Despite the fact that this fund specifically excludes financial stocks, it has a trailing three-year volatility that is 44% higher than that of the S&P 500 and a 4.5% yield. There are no options for DOO, so I assume that its historical volatility is a guide for its future volatility, at least on a relative basis. Similarly, the SPDR S&P International Dividend ETF (DWX) has a yield of 6.8% but has a trailing three-year volatility that is 66% higher than that of the S&P500. For reference, the high-yield bond fund (HYG) has an 8% yield with trailing 3-year volatility that is 13% lower than that of the S&P500.
Income investors should not be seduced by the higher yields of European stocks . The direct measures of risk provided by options on ADRs and U.S.-listed foreign stocks provide unique insight. Despite some apparent great deals, many more stocks have a high potential to become value traps. Because of the wide variability of yield vs. risk across stocks, income investors should avoid broad-based dividend-oriented funds of European stocks – unless they use screens to control for risk, as I have done in this analysis.
Geoff Considine is founder of Quantext and the developer of Quantext Portfolio Planner, a portfolio management tool. More information is available at www.quantext.com.
Geoff’s firm, Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com), an innovative brokerage firm specializing in offering and trading portfolios for advisors and individual investors.
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