These funds may offer some downside protection at a time when stock and bond yields are low and valuations full.
By Alec Lucas, Ph.D. | 10-10-17 | 06:00 AM | Email Article

This article was originally published in the June 2017 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

Alec Lucas is a senior manager research analyst for Morningstar.

"Anybody that prefers bonds today to stocks is making a big mistake." That's what Warren Buffett said in a May 2017 interview about the prospects of investing in a 30-year bond versus equities in the interest-rate environment at the time. Little about that environment has changed since, and Buffett recently reaffirmed his view that stocks, despite trading at record levels, offer a better deal than bonds.

Bonds' sensitivity to rising interest rates supports Buffett's belief. On July 5, 2016, and then a few days later on July 8, the yield on the 10-year Treasury closed at a record low of 1.37%, below the S&P 500's 2.10% dividend payout at the time. Such yields offer more risk than return. Indeed, the 10-year Treasury's yield rebounded from there, even shooting up after the U.S. election to 2.6% by mid-December 2016. The 123-basis-point increase showed how vulnerable bonds can be to short-term interest-rate spikes. The Bloomberg Barclays U.S. Aggregate Bond Index lost 4.1% over that period, versus an 8.8% gain for the S&P 500.

A conservative bond portfolio, especially one with modest interest-rate risk, offers more downside protection over the long term than equities. The challenge, though, is that its income advantage remains muted at present. As of September 2017, the S&P 500 offered about a 2.0% yield versus 2.5% for investment-grade bonds. That's arguably too little compensation for the upside potential one gives up by choosing bonds over stocks.

Turning to equities for income can lead to substantial loss of capital. Over the past 40 years through September 2017, the S&P 500's worst one-year price return was a 44.8% loss between March 2008 and February 2009. Investors also had to suffer through a two-and-a-half-year bear market in the early 2000s. Yet, capital loss isn't inevitable. The S&P 500's price return was positive in 78% of rolling one-year periods during that same 40-year stretch. The figures for positive price return were better during longer holding periods: 84%, 80%, and 92% of rolling three-, five-, and 10-year periods, respectively.

Investors have fine passive and active options to choose from. Passive dividend strategies with Morningstar Analyst Ratings of Gold and Silver, respectively, include  Vanguard Dividend Appreciation ETF , which tracks the Nasdaq U.S. Dividend Achievers Select benchmark and currently yields nearly 2.1%, and  Vanguard High Dividend Yield ETF , which tracks the FTSE High Dividend Yield Index and yields about 3.0%.

Here are three Silver-rated actively managed dividend strategies still open to new investors. The total return of each outpaced its most relevant passive rival, whether Vanguard Dividend Appreciation ETF or Vanguard High Dividend Yield ETF, over the past decade through September 2017.

Run since 2000 by Tom Huber,  T. Rowe Price Dividend Growth focuses on firms that are financially healthy enough to increase their dividends over time, but it also pays heed to their valuations, growth prospects, and management. Its 1.4% yield doesn't lead the way, but the fund has preserved capital better than the S&P 500 in major market downturns during Huber's tenure.

 Invesco Diversified Dividend has generally held up better than the S&P 500 in downturns, too, though 2011's third quarter was an exception. Meggan Walsh has led the fund since 2004. She looks for dividend-paying stocks with at least 35% upside from their current share price based on cash flow and other valuation measures. The fund's current yield is 1.6%.

 Vanguard Equity-Income's 2.5% yield is the highest of the three actively managed funds, thanks in part to its modest 0.26% expense ratio. Since late 2005, the fund's assets have been split between anchor Wellington Management and Vanguard's in-house quantitative equity group. Wellington's Michael Reckmeyer, who runs about two thirds of the fund, looks for stocks with above-average dividends and low valuations but unappreciated growth prospects.  

Securities mentioned in this article



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Alec Lucas, Ph.D. does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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