June 5, 2012
The maximum-yield mutual fund portfolios (red curve) have a consistently higher yield than the equivalent ETF portfolios. It is important to bear in mind, however, that the yield-versus-risk measure does not account for the impact of fees, which tend to be higher for mutual funds.
The S&P 500 has trailing 3-year volatility of 15.6%, so the results above mean that it is possible to create a portfolio out of the ETFs from the table above with a yield of 6% and the same volatility as the S&P500, even with the 50% maximum allocation constraint. This portfolio has the following allocation:
50% IST
37.5% IXP
12.5% CVY
A portfolio that is 50% allocated to each to HFQAX and EDIAX (the two dividend-focused mutual funds discussed earlier) has trailing volatility of 14.9% and a yield of 6.6%. If we exclude these two funds from the sample of mutual funds and then optimize to get the highest yield possible for a volatility of 15%, the maximum yield is 5.6%. The ETF efficient frontier has a yield of 5.8% at this risk level.
These optimized results do not mean that these are the best portfolios on a going-forward basis, but they do illustrate that investors can do better than the yield and risk of the S&P 500 using a portfolio of dividend-focused funds or ETFs. In general, investors prefer to constrain the maximum allocations to any given fund or asset class far more than I have in these examples.
Investors must recognize the enormous range of volatility for equity funds with a specific yield. There are funds whose yields approach 5% with volatilities below 15% and others with volatilities as high as 30% or more. Investors whose primary consideration is income should avoid funds with volatilities greater than 20%.
The fact that a fund is not close to the efficient frontier does not rule it out as an attractive portfolio component, however, because even a higher-volatility, lower-yield fund may have positive diversification effects. This would result in a portfolio with improved yield vs. risk even if one of the funds is not terribly attractive on a standalone basis. Furthermore, there are many classes of stocks with high growth potential that pay small dividends or no dividend at all. The yield-versus-risk frontier pertains only to the component of return represented by income.
Conclusions
With Treasury yields near all-time lows, many investors are chasing yield and pouring money into dividend-oriented stock funds. The perils of doing so are evident from the level of risk in many of the funds above. A fund that has “dividend” in its name may still be very risky. On the other hand, there are good reasons to prefer dividend-paying stocks.
Even if one does not believe higher-dividend stocks will provide higher returns relative to risk, investors should still favor them on the basis of higher earnings quality and lower estimation risk for future returns. In the case of funds with high volatility, however, dividends will typically be a smaller component of total return, so this value proposition is less compelling.
Even in the current low-yield environment, one can create a portfolio of equity funds with a yield as high as 6% and the same level of historical volatility as the S&P 500. Investors seeking yield indiscriminately, however, may end up with considerably more risk than they expect. Historical risk values for mutual funds and ETFs are readily available from Morningstar, and one can compare a fund to its benchmark and alternatives. Any dividend-fund investor should do his or her homework first – then prepare to be pleased with the results.
Appendix : Funds sorted on yield / risk
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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