|Author ||mgerstein ||Subs || 42 |
|Launch ||03/07/13 ||Cost ||FREE |
|Rebalance ||02/17/14 |
High yields are obviously appealing, especially in today's exceptionally low interest rate environment. Yet we know, both from theory and research, that high yield comes at a stiff cost -- challenging company prospects leading to increased risk of dividend reduction or elimination and/or poor prospects for future dividend growth.
But despite the obvious obstacles, many remain drawn to high-yielding stocks. Emotion may play a role here, but there's more. An 8% annual return, for example, that is all or primarily income differs quite a bit from an 8% return that is all or primarily capital gains even beyond tax considerations. Receipt of income provides immediate opportunities for consumption and/or reinvestment. The latter could be especially important in times of rising interest rates; this is what often motivates fixed-income investors to sometimes be willing lock in capital losses by purchasing high-coupon bonds priced above par. Formal concepts such as fixed-income "duration" don't exist in the equity market, but income seekers often gravitate toward the same notions (monetizing more of their returns more quickly). So it makes sense in ways that aren't necessarily apparent from conventional back-test data for income-oriented equity investors to try to manage the risks associated with higher yields, as opposed to looking only at data based on total return.
This strategy attempts to capture above-average yields while at the same time keeping risk to tolerable levels. For the initial screening, the model relies heavily on "Mr. Market" (data on yields, trends in yields, and yields relative to comparables) to assess risk. If the market is perfectly efficient (i.e. if stock prices properly reflected all relevant information), we'd be able to stop here and choose among yields that seem high, but not too high. Recognizing, however, that inefficiencies do exist, the model goes further and prioritizes among Mr. Market's aggressive-income candidates on the basis of a ranking system that considers dividend security, dividend growth prospects, company quality, and traditional stock valuation.
The model is re-balanced every four weeks. Testing shows that in the past, performance would have been almost identical had the re-balancing been done once every three months. But given that we are higher-than-normal on the income-seeker's risk-reward range and that the differences in turnover between the two re-balancing protocols is modest, it seems worthwhile to accept slightly higher trading costs in return for the prospect of the model selling out of of future problems -- should any arise -- more quickly. Hence the model is being offered only on a four-week-rebalancing basis. (In theory, rotating stocks every four weeks could cause us to miss out on some quarterly dividend payments due to timing, but testing indicates that in practice, the risks of this are negligible. (i.e., We're really getting our dividends!)
The strategy includes flexibility regarding target yield ranges in an effort to accommodate changes in interest-rate environments. It may, however, become necessary to make further adjustments in the future.
Note that the model attempts, as far as practicable, to omit royalty trusts (which have specific termination provisions), master limited partnerships (which entail tax considerations deemed by many investors to be overly cumbersome), and real estate investment trusts (where the interpretation of data differs from what we're accustomed to with corporations).
This model aims to hold approximately 10 stocks and it allows no more than 35% of the portfolio to be concentrated in a single sector. It's fully invested at all times: i.e., it does not use market timing.