Brad Kinkelaar, Cliff Remily, Raji O. Manasseh
You don’t have to look very far these days to find yield-oriented investors starving for attractive income options. With 10-year Treasuries yielding about 2%, the usual playbook of generating income from a simple portfolio of government bonds has proven inadequate. This has serious implications for investors: As the large number of people born between 1946 and 1964 – the baby boomers in the U.S. – begins to retire, many retirement portfolios, once the recipients of net inflows, are under the strain of increasing distribution requirements.
In search of solutions, many investors now include dividend-oriented equities in their asset allocations. In an effort to reach their income goals, the temptation is great for these many investors to simply survey the local U.S. market and buy the highest yielding stocks. But we believe that in many cases, investors are over-reaching for yield in the wrong places and for the wrong reasons, which could have negative consequences for those sensitive to downside risk. In our view, global equities can provide more attractive dividend income opportunities and offer potential for additional benefits, including diversification.
The dangers of a home bias todayWith the current yield environment as backdrop, dividend equity strategies have enjoyed significant popularity. Over the past year alone, these strategies have received over $41 billion of net inflows, despite outflows of an equal magnitude from all equity funds. As a result, some have called dividend investing a “crowded trade” or “overvalued,” and recent articles in the press have warned that dividend funds carry “considerable risk” and are an “unsafe bet.” One even warned the unknowing “dividend stampede” that it faces a dilemma in owning dividend equities. The one thing all of these warnings have in common is that they address a U.S.-focused dividend approach, and for this reason, we think they may be right.
We believe the root of the problem for portfolios today, from individual retirement accounts to institutional pensions, is home market bias. Think of it as putting all your eggs in one basket: With this home-market bias, U.S. investors risk severely limiting their income potential because yield opportunities in the U.S. are slim pickings, in our view. Beyond telecom and utilities, no U.S. sectors yield much more than 3% today. Dividend managers constrained to the U.S. might reach beyond these sectors to include real estate investment trusts (REITs) or master limited partnerships (MLPs), but the universe is still relatively narrow.
Constructing a dividend equity portfolio with a home market bias thus shifts the focus from being diversified across sectors to reaching for yield and overweighting securities in a narrowly defined group. This increases concentration risk in the portfolio and the potential for loss if one sector falls in value. Despite this risk, over the past year, the majority of inflows have gone to U.S.-focused dividend mutual funds and exchange-traded funds (ETFs), prompting much of today’s concern.
Beyond the dearth of yield among U.S. equities generally, we think there are other fundamental problems with a U.S.-only dividend strategy, including:
Ongoing benefits of going globalA U.S.-centric portfolio constraint may be artificial and unnecessarily exclude the vast majority of available dividend stocks. A viable alternative is going global and unconstrained. We see a variety of reasons to embrace this approach to dividend investing, but we’d like to highlight three:
ConclusionThe low yield environment has prompted many income-hungry investors to add dividend-oriented equities to their portfolio allocations. With so many investors piling in, have dividends become a “crowded trade” and an “unsafe bet?” Do they present investors with a clear and present danger and a dilemma? This may sound like hyperbole, but in the U.S., dividend payout ratios are in a long-term decline, taxes on dividends are potentially on the rise, and valuations in sectors that typically offer attractive dividends are near historical highs. For the investor whose dividend investments are focused in the U.S., these are certainly reasons to pause. However, the evidence suggests that for the global dividend investor – unconstrained by geography, market capitalization and benchmark – attractive opportunities still abound.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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