Destroying Steady Income Streams

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For many endowments, foundations, and other investors, a steady income stream is lifeblood for their investment strategy. On one hand, markets offer a wide variety of securities (e.g., stocks and bonds) precisely providing this. Indeed, there is a long list of companies with extensive histories of paying and increasing dividends – many of which are likely to continue (Figure 7) – and there is an even longer list of highly rated bonds that will pay steady streams of fixed income. On the other hand, it is unfortunate that many funds and portfolio managers effectively destroy what would otherwise be steady income streams as their investment strategies treat income as an ancillary concern.

I explain this unnecessary income instability and provide examples from some of the largest and most reputable investment funds. I also discuss three primary drivers of this phenomenon: myopic focus on total return, unintended consequences of investment mandates, and advisor over-reliance on statistical models.

The solutions section describes simple strategies that make steady income the top priority. Based on the pillars of quality and value, these strategies focus on income and provide a robust foundation for capital preservation and growth. They also facilitate a higher degree of transparency and should thus deliver more peace of mind to retirees and other investors.

The problem

There is strong demand for steady income. However, most investment products and strategies fail dismally in this regard. How do they destroy steady income streams and why would anyone do such a thing? I discuss the reasons why in the following section (Primary drivers) but first illustrate the nature of the problem here. Observe the increasing instability in dividend distributions from left to right in Figure 1. All else equal, income-focused investors should prefer the steadier income streams if they were aware of the disparity.

Figure 1: Dividend Histories

Source: Aaron Brask Capital. I intentionally footnoted the names of the actual benchmarks as my goal is not to disparage any particular fund, but rather to illustrate my point: even some of the best and most successful funds inject unnecessary volatility into their income profiles.

Starting on the left in Figure 1, I look at the dividend history of higher quality stocks. While I am confident in my ability to construct better models for quality, I used a history of paying increasing dividends as a proxy for quality (as defined by the NASDAQ Dividend Achievers Select Index). Paying dividends is generally acknowledged as a positive attribute in terms of quality and increasing dividends even more so. The middle and right charts show the dividend histories of the broad market (as defined by the S&P 500 index) and the renowned Dodge and Cox Stock Fund, respectively.

While each of the above portfolios suffered declines in its dividend income, the quality portfolio experienced the smallest decline in dividends and highest growth. Dividends fell less than 5% peak to trough during the credit crisis and grew at an annual rate of 9%. Overall, the simple litmus test of historically increasing dividends resulted in a more reliable and faster growing income stream relative to the broad market. The broad market’s dividends suffered a decline of more than 23% during the credit crisis and the average annualized growth over the decade was just 7.3%.