Systematic Outlook

US Equity Income Outlook 2020 - Extracting Income Opportunities from Volatility 

01/13/2020

Trade wars. Impeachment. Elections. Recession. War in the Middle East. Liquidity shortfalls. Unprofitable startups. These are all potential triggers for market volatility in 2020, set against a backdrop of robust equity valuations, narrow Treasury yields, and thin credit spreads.


Of course, no one can control how investors might respond to these would-be events. We’re no more able to forecast what will trigger a market downturn than we can predict a sustained rally. Besides, Parametric isn’t in the crystal-ball business. Instead we think it makes more sense to focus on what we can control: systematic, cost-effective implementation of diversified exposures.


But whatever shocks 2020 has in store for investors, there are ways to mitigate the effects and even provide a pathway to attractive long-term total returns. Let’s look at two of the ways income investing may help with boosting returns in the new year.


Short-term volatility is uncomfortable, but is it bad for long-term investors?

Exchange traded closed-end funds (CEFs) largely raise capital only during an initial offering, provide a fixed number of shares to primary investors, and thereafter trade shares on public exchange. Though fund administrators typically communicate the fair value of net assets (or NAV) at the end of each day, the prevailing market price tends to stray from NAV—often materially. The CEF market provides one visible example of how far market prices may drift from a dispassionate measure of intrinsic value during volatile periods.


The difference between the two “prices” reflects a premium (or discount) when a CEF’s market price is above (or below) NAV. A CEF’s payout policy transfers value created within the fund to shareholders over time, forging a natural alignment with long-term, income-seeking investors. In the short term a CEF’s fixed share count prevents arbitrage mechanisms, aligning market prices with NAVs like those embedded in open-end mutual funds and ETFs centered on creating and redeeming shares.


In times of market stress, CEF owners often seek liquidity well in excess of what’s available near prevailing prices, forcing discounts to emerge and expand. Such nonfundamental trading embeds an impairment in market price that, by definition, exceeds the market-determined impairment of the underlying assets and thus creates an opportunity for long-term investors.


Historical transitions from drawdown to recovery have been sudden and acute, further challenging market timers who struggle to accurately call the top as well as the bottom. CEF investors may be better served by a structural allocation that defuses downside risks while participating in subsequent recovery cycles.


Unlike investments in more efficient markets, individual CEFs tend to reflect shocks at different speeds and magnitudes—even if the underlying economic drivers are similar. A systematic, diversified approach to trading through volatile periods enjoys a sequence of opportunities to enhance the strategy’s overall cash flow and valuations by taking advantage of the market as it is, not as it should be.


Dividend payers shine when times are tough

Investors often make equity allocations to capture elevated long-term growth prospects despite the increased volatility relative to fixed income securities or simply holding cash. But what if you could enjoy long-term capital growth without as much volatility—while also capturing elevated cash flows? Dividend-paying equities are naturally resilient to market volatility for at least two reasons: an ability to redirect existing cash flows from shareholders to fund operations in particularly tough times and to sustain the long-term link between operating performance and investor experience even if multiples reflect transitory fears.


In addition to broad US equity market data, Kenneth French, a professor of finance at Dartmouth College’s Tuck School of Business, also makes available historical equity data (from the Center for Research on Security Prices, or CRSP) sorted by dividend payer status and yield level at annual reconstitutions. Both capitalization-weighted and equally weighted portfolios of the same firms are measured. The table below includes sample statistics for each of the portfolios for the 40 years ending September 30, 2019.


CRSP equity data samples, 1979–2019


CSRP Equity

Source: CRSP, 9/30/2019. For illustrative purposes only. Not a recommendation to buy or sell any security or to adopt any investment strategy. Past performance is not indicative of future results.

These portfolios, based on simple annual sorts, initially tell three stories with the equity paying income:

  • Nonpayers, either on a cap- or equal-weighted basis, underperformed the cap-weighted market, with elevated levels of volatility. 
  • High-dividend payers outperformed the market, with less volatility. 
  • Equally weighting the same top 30% of dividend payers ranked by dividend yield resulted in nearly doubling the long-term outperformance (+191 bps) of cap-weighted payers relative to the market (+101 bps), with only an incremental increase in volatility.

The table below breaks apart the same return data into upside and downside capture ratios relative to the broad CRSP US equity market.


CRSP equity data samples, 1979–2019 (upside capture vs. downside capture)

CRSP Equity

Source: CRSP, 9/30/2019. For illustrative purposes only. Not a recommendation to buy or sell any security or to adopt any investment strategy. Past performance is not indicative of future results.

Notably, the outperformance of a dividend-payer portfolio isn’t predicated on capturing the full upside of the market. It’s based on capturing much of the upside and participating less on the downside. Giving equal weight to these payers can increase outperformance through both the incremental increase of the upside and the decrease of the downside.


Lastly, the National Bureau of Economic Research (NBER) identified five economic contractions over the last 40 years: 1980, 1982, 1990, 2001, and 2008. Each contraction captured historical equity behavior when times were particularly tough. Using the same equity as displayed in the two previous tables, the chart below summarizes the average of:

  • The peak drawdown associated with each contraction
  • The subsequent six-month return from peak drawdown
  • The cumulative experience of peak drawdown and six-month recovery

US equity drawdowns associated with the last five economic contractions

US Equity Drawdowns

Source: CRSP, 9/30/2019. For illustrative purposes only. Not a recommendation to buy or sell any security or to adopt any investment strategy. Past performance is not indicative of future results.

As we can see, dividend payers proved resilient—particularly relative to portfolios of nonpayers. Although nonpayers experienced stronger six-month returns after peak drawdown, the immediate recoveries fell short of offsetting the magnitude of the peak drawdown. Equally weighting top-yielding dividend payers averaged a slight gain, while a capitalization weighting of the same dividend payers nearly broke even, on average, six months after the peak drawdown.


In tough times, exposure diversification preserved the defensive qualities of equity income investing while more broadly capturing the immediate recoveries. This helped dividend-payer portfolios shine brightest without having to call both the top and bottom of the cycle.


The bottom line

Many of the market’s key performance indicators seem to suggest that volatility is on the horizon for 2020. Liquidating portfolios and moving to cash may be costly not only in direct costs—including trading costs and taxes—but also indirectly through opportunity costs of remaining fully invested. Consistent market timing—calling both the top and the bottom—is not as realistically achievable as simply increasing time in market, even if it means rough terrain from time to time.


Durable cash flows allow investors to derive utility from portfolios during uncertain times and help investors focus on long-term performance. When market prices and valuations are more depressed than underlying securities and businesses are truly impaired, distributions still reflect an objective reality.

 

Enhancing exposure diversification is one of the few things that can be controlled in the face of the unknown and decreases the need to call the top and bottom of economic cycles. Income-oriented strategies employing systematic diversification can translate volatility into opportunity. These strategies may earn an evergreen role in client portfolios by shining brightest when storm clouds obscure the path ahead.

Potential Parametric solution

Our US Equity Income strategy seeks to build a diversified portfolio of durable dividend payers in order to provide a steady source of dividend income while outperforming the Russell 1000 Value index on a total return basis.



Alex Paulsen, Director of Research

Alex is responsible for supporting new product research and development initiatives as well as all aspects of dividend equity and closed-end fund strategies. Prior to joining Parametric in 2012, he worked at BlackRock Alternative Advisors, the Fund of Hedge Funds unit of BlackRock, executing hedge fund investment reviews as well as ongoing risk management efforts for long/short equity and equity-related hedge fund strategies. Alex earned an MS in management and regulation of risk from the London School of Economics and Political Science as well as a BS in economics from the University of Washington.


The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.


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