June 5, 2012
What immediately jumps out is how important it is to look at volatility. DWX, for example, has much higher volatility than either SDY or PEY, both of whose risk and yield are remarkably similar to those of the long-term Treasury bonds.
The S&P 500 has a trailing 3-year volatility of 15.6%, which provides a risk benchmark. Quite a number of these funds have been much more volatile than the S&P 500.
One note for the close reader of the table above: CVY, an ETF with high yield relative to its risk level, is not a pure equity fund. The fund holds preferred shares, MLPs, and mortgage REITs. Any of the pure equity funds in the list above could generate more yield with the same or lower risk if they were allowed to invest in these asset classes.
I have performed a similar search to select dividend-focused mutual funds; the same data for these funds can be found in the table below.
High-yielding dividend mutual funds
The first two funds, HFQAX and EDIAX, have more than twice the yield with only slightly higher risk than SDY. Morningstar classifies HFQAX as a world stock fund with a large value style. It holds 2.6% in cash, 17.9% in U.S. stocks and 79.6% in non-U.S. stocks. On the basis of yield-vs.-risk, this fund is impressive. EDIAX is also classified as large value fund. A concern with these two funds, however, is their very high annual turnover (127% for HFQAX and 124% for EDIAX ), which means that investors are relying on the fund managers’ ability, rather than on the persistence of dividends . High turnover also detracts from performance through brokerage costs and bid-ask spread for the fund’s trades.
The table above highlights why investors need to be cautious about selecting funds on the basis of yield alone. Oppenheimer International Small Cap fund, OSMAX, has a yield of 4.3%, far above that of the S&P500, for example, but the risk associated with this fund is substantial. Investors owning such a fund are implicitly betting on substantial price appreciation to supplement yield and offset the risk that they assume.
The risk versus yield frontier
I first introduced the idea of creating an efficient frontier for yield versus risk (as opposed to expected total return versus risk) in October 2010.
Overall, the spectrum of risk versus yield for mutual funds is very similar to that for ETFs, as we can see in the chart below.
Risk vs. Yield for the ETFs and Mutual Funds (larger circle is long-term Treasury ETF)
The available yield increases with the risk of funds up to volatility (in other words, risk) of 15%-18%. As risk increases above this level, the available yield starts to drop.
There is a natural maximum yield that is available to fund investors. Adding risk to a portfolio by adding higher-risk assets reduces yield once you pass a specific risk level, because the fundamental nature of the stocks changes. High-risk stocks (such as technology stocks, for example) are less likely to pay substantial dividends, as their high volatility and low dividend payouts reflect the uncertainty of their future earnings .
The chart above also depicts the efficient frontier of yield versus risk for ETFs and for mutual funds. The solid blue line on the chart (labeled ETF Frontier) represents the maximum yield available at a given level of risk by combining the dividend ETFs to form a portfolio with a specific level of risk, then optimizing those combinations for yield. The mutual fund frontier is very similar (shown as a solid red line).
I have limited the maximum allocation to any single fund to 50%. This is somewhat arbitrary, of course, and lower maximum allocations allowed for the optimization will result in lower maximum yields. The maximum yield portfolios are generated using Quantext Portfolio Planner.
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