Where to Seek Equity Income

By Russ Koesterich, CFA, Chief Investment Strategist for BlackRock and iShares Chief Global Investment Strategist.

During the 25 years prior to 2009, investment income was ridiculously easy to come by. Doing something as simple as buying a 3-month Treasury bill produced an average yield of nearly 5%. That all changed, however, in late 2008, when yields dropped.

Since then, investors looking for income have had to become more creative, and many have looked to equities for income.

But with the bull market now more than 5 years old, you may be wondering whether this approach still makes sense. My answer: Yes, assuming you can take the volatility and look beyond U.S.-focused funds.

To be sure, as I pointed out recently, I’d be wary of seeking income at all costs and ignoring valuation. In other words, asset class cross-dressing, or using stock portfolios to generate income while simultaneously building equity-like exposure in bond portfolios, is becoming risky in some scenarios.

However, there are segments of the dividend space that still look interesting: international and global dividend stocks. Here are two reasons why:

Stocks are still cheaper than bonds. While stocks are no longer cheap, they are cheaper than bonds. One way to measure this – particularly for investors focused on income – is to compare the yield available from a bond fund to the yield available from an equity alternative.

Since 1995, the dividend yield on a broad global benchmark (the MSCI World) has, on average, been 40% of the yield generated from an investment-grade bond index (Moody’s Aaa). Today the ratio is closer to 60%.

While this is below the record of 80% recorded two years ago, it still compares very favorably with the norm. In addition, equities have three additional advantages over bond alternatives: tax treatment favors dividends, stocks have the prospect for future capital gains and stocks can provide a better inflation hedge.

International dividend funds look cheaper than U.S. focused funds. While stocks offer better value than bonds, I would bring up exposure to international and global dividend funds rather than focus exclusively on U.S. dividend funds, which look more expensive. Reflecting this fact, dividend yields in the United States are low compared to the rest of the world. The S&P 500 yields roughly 1.9% versus 3.3% for other developed market stocks (MSCI World ex-USA Index) based on World ex-US and 2.70% for emerging market equities (MSCI Emerging Markets Index).

At less than 2%, the current U.S. dividend yield not only looks relatively low compared to the rest of the world, but it also looks low compared to its own history. And while the yield on U.S. equities is close to its long-term average, the yield on other developed market stocks is nearly 30% higher than the norm.

Still, there’s no getting around the fact that stocks are no longer cheap. Given current valuations, I would expect returns over the next five years to be substantially lower than the previous five.

In addition, investors need to remain mindful of risk. While stocks are cheaper than bonds, equities generally come with more volatility. Today the case for equities as a dividend source comes down to relative value: Stocks are cheaper than bonds while simultaneously providing some upside potential.

The bottom line: For investors looking for income, international and global dividend funds are still a reasonable choice, at least given the alternatives.

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The D2 Capital Management Multi-Asset Income Portfolio is overweight in global and international dividend funds. Current yield on the portfolio is 5.46% and year to date the portfolio is up 9.27%.

Disclosure:  I own the D2 Capital Management Multi-Asset Income Portfolio.

The views expressed here are that of myself or the cited individual or firm and do not constitute a recommendation, solicitation, or offer by myself, D2 Capital Management, LLC or its affiliates to buy or sell any securities, futures, options or other financial instruments or provide any investment advice or service. D2, its clients, and its employees may or may not own any of the securities (or their derivatives) mentioned in this article.

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