What's in the Beef?
Besides ETFs, the United States is one of the world's leading producers of beef. But the industry has not been without its share of difficulties, including numerous bans by different countries during this decade. In fact, initial discoveries of Bovine Spongiform Encephalopathy ("mad cow") in December 2003 continue to taint American beef exports.
But beef isn't our beat ... we prefer the world of money and markets. Recently, investors have similarly found a few contaminants in their own investment holdings. Beginning with sub-prime mortgage backed bonds, asset-backed commercial paper of all stripes have been relegated to the "infected" pile with no buyers to be found. A closer examination of the content showed that not enough additional yield was awarded for commensurate increases in risk.
Income Strapped But Still Searching. With the backdrop of worldwide declining yields, it's no wonder investors had been venturing out farther on the risk curve searching for higher yielding instruments. It has been a long decline. The average S&P 500 dividend yield was 4.2% during the 1980s, dropping to 2.4% in the 1990s, and only 1.5% so far this decade. While S&P 500 earnings have soared this decade, today's payout ratios (the proportion of earnings paid out to shareholders in the form of dividends) are in the bottom quartile, as compared to the period from 1950 to 1991.
Similarly, in longer dated bonds, yields have come from a high of over 13% in the early eighties to about 4.5% most recently. Corporate bond and emerging debt spreads have also collapsed, providing very little incentive to venture out on the risk curve.
Clearly, we are now in an environment of lower yields while the demographic shift taking place will only increase the demand for dividends and other income-oriented products. (The first US Baby Boomer filed for Social Security benefits earlier this month). But risks shouldn't be ignored while attempting to secure higher yields.
Yield Hogging - Alternatives to the Dregs. Turning to the recent rash of income ETFs, consider these investment categories for yield oriented portfolios:
• Dividend-weighted ETFs: Challenging traditional market capitalization weighted indexes, the ETF industry's forays into the alternative weighting field has caught our attention. WisdomTree has a full and expanding suite of dividend-weighted ETFs based on the premise that over the long term companies with lower price earnings ratios and higher dividends usually outperform the more exciting growth companies with higher price earnings ratios and meager payouts. WisdomTree's Emerging Markets High-Yielding Equity Fund (NYSE:DEM) has a dividend yield of almost 6% and is overweighted in emerging Asia markets where we are more bullish long term.
Many Asian countries (ex-China!) still trade at discounts to developed markets. Since many of these emerging companies are growing in the same pool of earnings as developed multinationals a secular convergence of valuations seems likely. Significant recent capital investment, healthy country balance sheets and bulging foreign exchange reserves all bode well for future long term returns and sustainable dividend payouts.
• Timberland: Claymore Investments has filed papers with the US Securities and Exchange Commission for the right to launch the first US-listed ETF tracking a global timberland index. Stable income that is non-correlated to the stock market makes timberland investments an important part of diversified portfolios. According to data compiled from the National Council of Real Estate Investment Fiduciaries (from 1960 to the present), timberland has had only three negative years and beaten the stock market over that time. We'll be on watch for this new listing from Claymore.
• Domestic and Foreign Bonds: Recent issues of ETFocus have extolled the virtues of including bonds. ETFs cover an increasing number of areas in global debt markets, both in government and corporate sectors. International bonds are also a key area which should be considered. For Canadian domiciled accounts, at the least it makes sense to partially diversify currency exposure (recent speculative flows show a record net long in the Canadian dollar, indicating that historical positioning has reached definitively extreme territory). Asian bonds are an excellent example of a foreign fixed income market with low correlation qualities, in addition to higher yields, attractive value and sufficient liquidity. Improving credit quality, significantly undervalued currencies and positive structural economic reforms in the emerging Asian region herald attractive returns. The Hong Kong listed ABF Pan Asia Bond ETF (HKSE:2821), a basket of Asian currency denominated bonds issued by both government and quasi-government organizations in developing Asia, fits the bill here.
• Preferred shares: In light of the Canadian federal government's decision on income trusts, preferred shares present a lower volatility alternative. Claymore's S&P/TSX Canadian Preferred Share ETF (TSX:CPD) bundles more than 50 securities, reducing issuer specific risk. The offering currently yields close to 5%, not to mention preferential tax treatment for taxable accounts.
• Income-focused ETFs: In a December 2001 study entitled "Does Dividend Policy Foretell Earnings Growth?", researchers Robert Arnott and Clifford Asness found contradictory evidence to the commonly held view that low payout ratios lead to higher future earnings growth. The authors detail historical evidence over the period from 1950 to 1991 suggesting the opposite correlation - that is, earnings growth is fastest when payouts are high. A key implication of increased global trade is no country wanting a strong currency. With the Federal Reserve beginning to decrease the fed funds rate and a trade-weighted US dollar that has already fallen nearly 20% over the last two years, many central banks will be reluctant to raise rates. In this environment of declining short rates, dividend yields will be even more secure than fixed income investments (and certainly relative to both short and long durations). In addition to the WisdomTree lineup, several ETF providers offer dividendfocused ETFs. Each methodology is different, including some screening process. For example, some dividend ETFs are based on companies with at least ten years of consecutive dividend increases, while others focus exclusively on the highest yielding securities.
Now to the Beef. As the ABCP fiasco has shown, selecting income focused investments should incorporate the usual screening process - primarily ensuring adequate diversification, reasonable fees, sufficient liquidity and an in-depth knowledge of the underlying assets. Of particular importance with dividend-focused ETFs, however, is their underlying sector and style biases. Notably, most will tend to have either a value or small cap tilt ...not necessarily a negative, depending on the investment outlook.
Currently, many are enormously overweight the financial sector, as the lending boom of the last several years has boosted profits and increased dividends. Consider the PowerShares High Yield Equity Dividends Achievers Portfolio (AMEX:PEY) with a financial weighting of over triple the S&P 500 (approximately 63% versus 20% in the broad S&P 500), and a small cap value weighting of about 54%.
With the credit crunch continuing in the US and spreading globally, we have had an underweight in financials and an overweight in US large-cap growth investments since the middle of last year. After seven years of both small cap and value outperformance, large growth is now outperforming this year. With international earnings continuing to be the fastest growth area for US multinationals, growth indexes are heavily laden with globally-diversified, non-cyclical companies. In comparison, value benchmarks tend to generate more revenue from domestic sources and are currently overweight financials.
Should the credit markets further tighten, cyclically sensitive and LBO-fueled small caps should underperform blue-chip multinationals as smaller companies will face higher hurdles in accessing credit. The supply of small caps could increase as private equity funds place acquired companies back on public stock markets.
Conclusions. Has a new environment of risk aversion emerged in financial markets? While the jury is still out, certainly a flight to quality in certain sectors has occurred over the last few months. Witness declining short-term bond yields, large inflows into money markets (according to the Investment Company Institute, US money market mutual fund assets have increased at a 60% annualized rate over the last 13 weeks to a record total of nearly USD 3 trillion) and some higher risk asset classes experiencing consolidation (see recent performance of many small capitalization equities).
For now, transparency seems bound to be a virtue once again held on high. Exchange-traded funds really shine in that category. With widely-diversified investments that have fully transparent holdings, intra-day pricing and no specific equity or corporate fixed-income risk, one cannot ignore the benefits.
Many investors may continue to ask "where's the beef?" But with dislocations in credit markets continuing, the more relevant question today is "what's in the beef?"