Today’s global recovery in dividends is stronger than most investors expected, with 84% of companies increasing their dividends or holding them steady compared to Q2 2020. Year-over-year dividend payouts were up over 26.3% in Q2 2021 – just 6.8% below 2019 levels (Figure 1).
As we’ve pointed out, cash-flow-driven investments (CDI) offer an important framework for the growing number of cash-flow-negative plans. Typically, CDI strategies use contractual, cash-flow-matching assets like government securities; unfortunately, underfunded plans can’t rely solely on these instruments to meet their future obligations. What’s more, the interest rate environment we’ve faced over the past decade and the lengthy nature of maintaining DB funding commitments further complicates the challenge.
That’s where adding cash-flow-aware growth to a CDI strategy becomes more valuable. A well-constructed allocation of assets dedicated to cash-flow-aware growth may help strengthen long-term outcomes by tapping a broader spectrum of income-generating securities, such as high-yield bonds and dividend-focused equities.
Dividend-focused equities, in particular, can be an essential source of income potential in cash-flow-management designs. This is because these securities have historically offered attractive, relatively stable long-term yield advantages over investment-grade credits throughout the low-rate environment (Figure 2). Plus, they offer the potential for long-term growth.
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About the MSCI World High Dividend Yield Index MSCI World High Dividend Yield Index targets companies with high dividend income and quality characteristics and includes companies with higher than average dividend yields that are both sustainable and persistent. Index construction starts with a dividend screening process: only securities with a record of consistent dividend payments and with the capacity to sustain dividend payouts into the future are eligible index constituents. MSCI screens securities based on certain “quality” factors, such as return on equity (ROE), earnings variability, debt to equity (D/E), and recent 12-month price performance. The goal is to exclude stocks that may cut or reduce dividends because of deteriorating fundamentals. MSCI includes only those stocks with higher than average dividend yields from the list of eligible companies, capping issuer weights at 5%. The index is market cap-weighted and rebalanced semi-annually in May and November. Source: MSCI. |
What to Look for in a Dividend Focus Strategy
Of course, equity dividend income comes with risks to contemplate, especially the potential for capital loss in a market drawdown. Hence, we believe you should consider two key evaluation criteria for strategies with a dividend focus: 1) dividend quality and consistency, 2) volatility and drawdown mitigation.
Dividend Quality and Consistency
Income reliability is critical for a CDI strategy to be effective. Consider the strategy’s long-term yield performance versus its benchmark and peer group. How has it performed in terms of yield delivery across a full range of market climates? For instance, the economic shock brought on by COVID-19 offered a severe test case, with many global dividend-paying stocks cutting or eliminating their dividend payouts. How did the strategy perform during and after this extreme environment as equity yields came under intense pressure? Some strategies may also use capital to boost income, which may not be optimal within a CDI framework.
Low Volatility and Drawdown Mitigation
Dividend-paying stocks have been historically less volatile than the broader equity markets over complete market cycles. Still, you should determine whether a strategy’s low-volatility profile is an explicit objective or simply the byproduct of the dividend-producing equities held in the portfolio. These features do not always work in concert.
Most strategies pursue high dividend income or lower volatility, but only a handful of strategies focus on both (Figure 3). With proven records of combining income and volatility reduction, these more defensive strategies may offer a particularly compelling component for a CDI sleeve focused on cash-flow-aware growth.
A Powerful One-Two Punch
Defensive equity strategies come with various names, such as low volatility, managed volatility, minimum variance, and adaptive volatility. Low- and minimum-volatility strategies typically pursue returns similar to cap-weighted equity benchmarks with much lower volatility over a full market cycle. Adaptive- and managed- volatility strategies attempt to exceed the performance of cap-weighted benchmarks with reduced volatility. While all defensive equity strategies typically seek long-term growth and some degree of volatility reduction, they may or may not include an income orientation.
However, combining a defensive posture and income orientation can make all the difference to a CDI strategy. Figure 4 illustrates why. It compares the median yields, standard deviations, and drawdowns of three groups of strategies: global large-cap core, global dividend focus equity, and global low volatility equity strategies.
A standout among the dual-classified strategies is Strategy B. The benchmark for this strategy is the MSCI World High Dividend Yield Index, providing the manager a universe of stocks already pre-screened for their dividend quality and consistency. Still, Strategy B offered a gross-of-fee yield greater than its benchmark’s, which was 3.4% as of June 30, 2021.
Given its dividend focus, the MSCI World High Yield Dividend Index was already 12% less volatile than its parent index but had a slightly worse maximum drawdown for the five years ended June 30, 2021. By integrating a defensive (adaptive volatility) approach over the same period, Strategy B further reduced volatility – 33% less than MSCI World Index volatility – and limited the maximum drawdown to -16.0% versus -20.9% for the MSCI World Index.
Together, this combination results in a unique risk-yield profile among all asset classes: a significant reduction in volatility compared to equities with yields similar to higher-yielding bond segments (see Figure 5).
Learn More
Defensive equity strategies with a dividend focus potentially offer an ideal solution in a CDI framework. These strategies have the potential to generate high equity dividend yields for short-term funding needs, considerably less volatility and drawdown risk, and the potential for upside growth for longer-term obligations. Download “How Your Cash-Flow-Negative Plan Can Use Cash-Flow-Aware Growth” to learn more about CDI strategies and growth strategies capable of supplementing cash-flow needs.
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