All investment strategies go through periods of outperformance and underperformance. GARD’s historical back test performance is exceptional, but returns this year have lagged the market considerably. What is the reason for this? In what environments do you expect GARD to outperform, and to underperform?
Historically, the strategy’s outperformance was due to the Guard Indicator capturing the two major bear markets between 2001 and 2015, the tech meltdown (2000 – 2003) and the credit crisis (2008 – 2009). There are two components to GARD’s performance – market timing (using the Guard Indicator) and security selection (based on the DIVCON dividend health rating system).
From a market timing perspective, the GARD strategy may underperform in the following scenarios:
– Bull markets with participation from only a few sectors. The Guard Indicator is designed to capture a broad based rally rather than one concentrated in a few sectors. For example, the Guard Indicator underperformed during the Internet bubble from 1998 – 2000
– When the market is range-bound, for example, ±10% for a prolonged period, then the Guard Indicator may switch on and off, giving false signals
– The Guard Indicator may not capture extremely sharp drops in the market because it is designed to capture prolonged bear markets
From a security selection perspective, it will typically underperform when lower quality stocks outperform higher quality stocks (e.g., what took place from March through June 2009). Earlier this year investors shifted to a significant “risk-on” approach we saw low quality names in Energy, Utilities and Materials (three of the hardest hit sectors in 2015) rally while high quality names kept pace with the overall market. From February through July of this year, Crude Oil surged 60% and Gold was up 80%. As a result, the low quality short portfolio components exhibited significant positive returns, negatively impacting performance.
What type of weighting scheme (equal weighting, market cap weighting, yield weighting, etc.) do you employ in your ETFs, and why?
We use a factor-based weighting tied to our proprietary DIVCON dividend health rating system. The DIVCON system scores and ranks companies based on a weighted average of seven fundamental factors which measure the relationship between historic dividend trends, cash flow and earnings, buybacks, as well as consensus forecasts and external financial ratings. The DIVCON Leaders and Laggards portfolios are then weighted proportionally based on the resulting DIVCON Scores for each dividend paying company in our selection universe. The healthiest dividend payers with the highest DIVCON Scores are weighted more heavily in the Leaders portfolio (the long component), while the unhealthiest payers with the lowest DIVCON Scores are weighted more heavily in the Laggards portfolio (the short component).
Vanguard recently closed its dividend growth fund. Do you think the large cash inflows into dividend strategies will negatively impact dividend investor performance going forward?
Large cash inflows into high-yield based dividend strategies will negatively impact investor performance in strategies, as many high yielding names are currently overvalued based on stronger-than-normal investor demand in the current market environment. As an example, Utilities make up just 3% of the S&P 500 market cap, but many of the largest inflows this year are going into dividend ETFs and funds with as much as a 30% allocation to the sector.
However, if investors utilize a forward-looking focus to make investment decisions, we believe dividend growth investing will continue to provide solid opportunities and exhibit strong performance going forward. Ultimately, investors should focus on future dividend growth, not current yield. If earnings continue to slide, the high yield, high payout ratio companies won’t be able to maintain their dividend and the stocks will become even more volatile. We believe investors should take profits now on their high yielding, low quality names, as they have significantly outperformed the market, and then transition those profits into stronger healthier companies with good prospects for future dividend growth.
Where do you see dividend investing headed in the next 10 years?
We don’t see dividend growth investing as a recent fad. Dividends in the S&P 500 have risen in the last 40 of 43 years and have grown at nearly 6.5% annualized over this timeframe. This performance is remarkably stable compared to the equity market, where since 1900 there have been 61 bull years and 54 bear years. As dividends tend to grow during bull markets and can compose a large component of total return during low growth market cycles, dividend growth investing should prove a solid investment strategy for the decades to come. The important thing for investors to consider is dividend growing stocks vs. high yielding stocks. Reality Shares research has shown many of the highest yielding names are also the unhealthiest from a fundamental perspective, while dividend growing stocks have historically outperformed dividend maintainers, dividend cutters and non-dividend payers in the S&P 500 since the early 1970s.
Final Thoughts
Thanks again to Eric Ervin of Realty Shares. Be sure to visit the Reality Shares site here.
I agree with Eric on taking a quantitative approach to dividend growth investing. I also agree that dividend growth investing is anything but a fad. Investing in high quality dividend paying businesses when they trade at fair or better prices is ‘common sense investing’.
Whether you invest in individual stocks or ETFs, a dividend growth investing approach (applied systematically) has historically produced favorable results.
Disclosure: None
