Investors seeking income are invariably tempted by equity funds offering above-average dividend yields. The problem? Higher yields may come at the expense of capital appreciation, resulting in lower total returns, and since a fund’s track record is often a poor indicator of future performance, investors can’t easily see which high-yield funds will keep pace with the broader market going forward.
So how to tell?
We turned to holdings-based analytics specialist Windfactor Investment Research for insight into which high dividend funds, if any, also show potential for strong total return.
Nathan Tidd, president, Windfactor Investment Research
A comparison of iShares exchange-traded funds (ETFs) suggests it matters quite a lot which high-dividend fund the investor chooses. For example, with Windfactors of 25 and 26 respectively the Core Dividend Growth (DGRO) and Core High Dividend (HDV) ETFs appear poorly positioned for the current market environment. However, the iShares Select Dividend ETF (DVY) – with a respectable Windfactor of 63 – shows an above-average chance of outperforming the US market next year.
An equity fund’s Windfactor is the statistical probability the fund will outperform a benchmark over the next 12 months, expressed as a value ranging between 0, if it is the benchmark, and 100 if outperformance is ‘historically certain.’ Our research indicates that investing in funds with higher Windfactors would have been a good bet over the past decade and will continue to be so as long as history keeps repeating itself.
Windfactors are derived from best-match returns, the average and volatility of historical one-year relative returns for similar companies during similar market environments. They leverage a unique business factor model that matches today’s firms with past firms based primary on industry, earnings drivers, management policies and market value. Best-match returns are reported in percent relative to the Windfactor US Market Portfolio.
Figure 1 shows recent and near-term fund performance for three high dividend iShares (DGRO, DVY, HDV) alongside the iShares Core S&P Total Market ETF (ITOT) for comparison.
Despite a solid three-year track record for DGRO, the fund’s Windfactor suggests performance over the next year may fall short of the broader market. This does not appear to be a simple momentum reversal, however, as HDV appears positioned for continued underperformance.
By contrast, the higher Windfactor for DVY suggests its outperformance over the past three years may well continue for another 12 months, which if realized would more than compensate for higher fund fees (39 basis points versus eight basis points).
Figure 2 shows the best-match historical performance underlying the Windfactor of each fund. While DGRO and HDV have similar Windfactors, reflecting a similar probability of outperformance under best-match conditions, the average underperformance for stocks similar to those held by HDV have been more than double that of DGRO (-3.9% versus -1.8%), but with greater variation around that historical average.
Look beyond yield
Figure 3 shows a selection of the business characteristics (factors) driving differences in best-match fund returns. While all three funds overweight firms with above-average dividends – which at current price levels could either help or hurt performance next year – the similarities end there. Their varying tilts toward firm size, investment levels, share buybacks and other characteristics all contribute to differences in best-match performance to the degree that consistently positive or negative returns have historically followed factor valuations similar to today’s.
As with other quantitative tools, using Windfactors and best-match returns to forecast next year's performance is a bet history will repeat itself, the difference being which part of history.
But the prospects for any fund in any given year are hardly certain. These analytics notwithstanding, with equities new things can happen anytime and changing business fundamentals can break past return patterns with lasting shifts in growth prospects. Following such events one can only hope for a swift ‘return to normal’, but even so it only stands to reason that good human judgment will remain a prerequisite for sustained outperformance.