Hedged-Dividend Investing: The Debate Starts

As I noted in our blog two weeks ago, a strategy we use as a core portfolio at Sungarden is based on the concept of hedged dividend investing. That is, we aim to achieve a portfolio income yield of 3% over the S&P 500 (or about 5% yield in today's market) not with high quality bonds, but via a combination of individual stocks, hedging securities and possibly some income-oriented ETFs. In the coming days, we will release a whitepaper explaining the rationale for this approach and its potential benefits to the investor and their financial advisor, based in part on a 20-year historical review of the approach.

As we expected, many readers of our blog and the sites it spreads to, are intrigued by the concept. We have used it for our own clients and feel strongly about its role in helping address the retirement income crisis that is gaining strength as retirees start to figure out that the bond market ain't what it used to be.

We also expected that many financial advisors who adhere to traditional investment approaches such as Modern Portfolio Theory (MPT) would spit on our idea. We assumed they would quickly point out that managing a hedged style as we do (though not in a hedge fund - we manage separate accounts only at this point) relies on developing an opinion on what direction the stock and bond markets will travel in, and that this is folly. Frankly, this seems odd to me considering that MPT is fueled in part by the development of estimated future returns on different asset classes. In other words, developing an opinion on what direction the stock and bond markets will travel in.

Anyway, here is one exchange I had online this week following our approach being featured by Investment News' veteran reporter Jeff Benjamin in that publication’s December 30 online issue.

The "commenter" to the article did so anonymously (using the online name “tune out the noise” ) so I cannot give him or her credit for their views. But I suspect there are many out there that feel the same way, and many that think we are on to something. Regardless of your view, isn't this what makes the investment advisory business so rewarding? I think that investors are happy to learn that such lively debate is common in our business and it existence promotes exactly what investors are looking for - flesh and blood people who can do the research for them, the planning with them and be willing to stand by their beliefs and act in their client's best interests. Here is the discussion, starting with the commenter’s reaction to the story describing the Sungarden approach to hedged dividend investing:

COMMENTER: Wow I think I will stick with bonds, gee whizz.

SUNGARDEN: I would suggest that by relying primarily on bonds today vs. the past three decades, you have tuned out not the noise, but the reality of the situation for retirees as well. But that's why they call it a "market" - lots of room for different opinions.

COMMENTER: You have a foot on the gas pedal and the brake at the same time. "Equity exposure can range from 10% to 80% depending on outlook and broader market analysis." Oh I get it now, you can predict the future! "Like a bond allocation it is less about performance than it is about reducing risk." Okay then why not use bonds? You can get a yield over the S&P with intermediate corporates right now and you don't have to create a hedge fund to do so.

SUNGARDEN: I can see you are not impressed. Let me clarify some things. The key part of the volatility management conversation, as Jeff captured in the article, is "Mr. Isbitts said the strategy's target beta, or percentage of the S&P's volatility, is at 50, but that he recognizes a “beta comfort zone” of between 35 and 65." In other words, we don't believe that a "moderate risk" investor should stay in the same place all of the time. Market conditions create reasons to tilt one way or the other. In EXTREME cases (2008 decline/2009 rebound) we want to give ourselves the flexibility to go another 15% in either direction, or 20 (in the case of a 2008 scenario) or 80 (in the case of a 2009 scenario). When modern portfolio theorists (I assume you are one but I don't know your name or firm so I can't be sure) rebalance their clients' accounts, I have seen this is often done AFTER a major change has occurred in the market. So, if stocks lose a ton of money, buy more stocks and sell bonds. BUT, that assumes that 1. the client has stuck around long enough to endure the stock decline (whereas a hedged investor feels pretty comfy) and 2. that moving into bonds at that point is not a suicide mission. Look at the recent market activity (2012-2013): stocks have roared, bonds have petered out and yield very little. Is this about the time that MPTers are rebalancing from stocks to bonds? This sure did work for the last 30 years! But now, from today's rates? THAT is our point at Sungarden - past is not prologue. Consider this: one part of our upcoming study on hedged dividend investing will contain a calculation we did off the current 10-year US Treasury Rate. If you buy the 10-year UST now at 3.03% and hold it for 5 years, the best return you can get is 4.67% a year for 5 years. Not bad, but that assumes that the 10-year goes to 0.00%. Your return is capped at 4.67%. How much could your client lose if rates went up? If the 10-year goes up 3% instead of down 3% as in the previous calculation, your annual price return? Negative 5.74%! That's 25% decline in the price of the bond. Add back your measly coupon, and then think about explaining a 3% total return drop each year for 5 years to a client that thought bonds were "safe" -- I am not nearly a good enough salesperson to talk my way out of that one. And what about using intermediate corporate bonds, as you say? Spreads are mighty low, so the numbers don't change a lot from the above…unless of course we have another credit crisis, in which case they would be much worse! So, as you say, some of us would rather have our foot on the gas and break simultaneously. At the end of the day, we'll stick to focusing on net equity exposure + dividends versus the classic stock/bond mix. To each his own.

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