High Yield Strategies – Elegant Design by Chris Brightman, Vitali Kalesnik and Engin Kose, Research Affiliates
- The AND principle holds that creative product design can surmount some trade-offs that conventional thinking considers unavoidable.
- Simple investment strategies are easier to govern than complex ones and may be less likely to result in catastrophic outcomes.
- A simple new design demonstrates that income-oriented indices need not trade off yield for capacity and quality.
“When you first start off trying to solve a problem, the first solutions you come up with are very complex, and most people stop there. But if you keep going, and live with the problem and peel more layers of the onion off, you can often times arrive at some very elegant and simple solutions.”
In January 2007 Steve Jobs announced a revolutionary product: the iPhone. Before that, phones were either easy to use but only had a single function, or multi-functional (“smartphones”) but hard to use. The conventional wisdom in phones, as in many areas of product design, was that trade-offs are inescapable: the consumer simply cannot have everything she wants delivered in one appealing product. But with the historic unveiling of the iPhone, Jobs proved the conventional thinkers wrong. The iconoclastic iPhone design showed that the consumer can enjoy a product with rich functionality and ease of use. We call this the AND principle. It guides all of our new product designs. Instead of accepting unnecessary trade-offs, we seek to combine the qualities investors desire in a single vehicle.
But before we explore the AND principle in more depth, let’s review two important elements in product design: structure and implementation.
The Challenge of Simplicity
“That’s been one of my mantras—focus and simplicity. Simple can be harder than complex.”
Structure is essential to product design. Structure can be simple. Structure can be complex. We agree with Steve Jobs that simplicity is often the more difficult to achieve, but we believe it improves on complexity in two major ways. Simple solutions 1) lead to more predictable outcomes, and 2) allow cleaner and easier oversight.
In the investment world, complexity leads to crises, crashes, and fund collapses. A short list of events over the last three decades in which complexity played some role includes the 1987 stock market crash, the late 1990s Long-Term Capital Management collapse, the 2000 bursting of the dot-com bubble, the 2007 quant meltdown, the 2008 global financial crisis, and the 2010 flash crash, among others. Simple strategies are exposed to unpredictable events—especially those with systemic effects—but, compared to more intricate structures, the way they will react under stress may be easier to grasp, transactions easier to unwind, assets easier to locate, and ownership easier to establish. (Recall the difficulties Lehman’s counterparties encountered when they tried to claim derivatives collateral after the firm filed for bankruptcy in 2008.3) Simple strategies may be less likely to result in catastrophic outcomes.
The second important advantage of simplicity is easier governance. For institutional investors, it means that an officer can understand and coherently explain to the board what the strategy is doing. Also, during periods of underperformance (let’s not kid ourselves, periods of underperformance are inevitable for any strategy), this ability to understand what the strategy is doing helps investors stay with the strategy. For individual investors, simplicity means that at the next BBQ party they will be able to explain why they are staying with the strategy instead of switching to some new “bright and shiny” magical stock that their neighbor just bought.4
A Design That Works
“Some people think design means how it looks. But of course, if you dig deeper, it’s really how it works.”
— Steve Jobs5
Designers charged with developing a new product should start by focusing on how that product can work best. For an investment product, that means they should focus on the components of return most valued by a particular type of investor. For many investors, total return is what matters, but some investors prefer to maximize the income component relative to the capital appreciation, or growth, component. Individual investors, for example, use portfolio income to meet their living expenses; defined benefit pension funds use current income to discharge their obligations to beneficiaries; university endowments need income to pay the institutions’ operating expenses; and charitable trusts dispense investment income to support their particular cause. Many investors with an income preference turn to high-yield equity products, those with relatively high dividend distributions.
Currently, investors with a greater preference for income have two product options to choose from: dividend yield–oriented products and dividend grower products. Figure 1 illustrates how these two products differ in terms of company quality (vertical axis), as measured by the average Standard & Poor’s credit rating of the constituent companies, and the dividend yield pick-up, which is the difference between the current dividend yields of the strategy and the benchmark (horizontal axis). The dividend yield–oriented products seek higher dividend–yielding stocks; that is, stocks with a record of high dividend payouts and a low current price. But the low price relative to dividends paid can signal one of two things: cheap future dividends (that’s what investors want!) or distressed and slow-growing companies that may stop paying dividends in the future (that’s what investors want to avoid!).
The dividend grower products seek stocks that have a lengthy history of positive, steady dividend growth. This strong historical record is an indirect proxy for quality and typically signals a healthy company. As a result, dividend grower products generally own higher quality companies than dividend yield–oriented products. But because a stock’s history of dividend growth is unrelated to its dividend yield (i.e., no bias exists toward higher yielding stocks), the stocks in this category typically have a lower dividend yield, as indicated in Figure 1, than dividend yield–oriented products.
The consequence is that dividend-oriented investors often must make a trade-off between quality and yield. Both high- and low-quality companies can have the same dividend yield. Not knowing which is which can introduce poorly performing companies into a dividend-yield portfolio. Some high-yield stocks are cheaply priced equity of high-quality dividend-paying companies. Other high-yield stocks are cheaply priced equity of low-quality companies with unsustainable dividends. Low quality can be explained by one or more of the following considerations: financial distress, unsustainability of profits, and poor accounting practices, sometimes even extending to fraud. Simply paying the lowest price for a given dividend is not an optimal strategy.
We believe the quality–yield trade-off is largely unnecessary. The challenge is to find the high-quality companies among those with high dividend yields. In an article we published in June 2015, “The Market for ‘Lemons’: A Lesson for Dividend Investors,” we showed that introducing company-quality screens in selecting stocks for a high dividend–yield portfolio can help investors avoid this trade-off.
Table 1 summarizes the main points of the “Lemons” article. The first line reports the average return and risk, realized dividend yield, dividend growth rate, and delisting characteristics of a large-cap index, which consists of the 1,000 largest companies by market capitalization. The second line reports the same statistics for a high dividend–yield portfolio, composed of the 200 companies in the large-cap index with the highest dividend yields. The high dividend–yield portfolio includes nine delisted