When you own a stock you’re taking a risk on that company, hoping to be rewarded for its future success. With bonds, you’re taking interest rate and credit risk on a locked-in interest rate paid long-term by the company. Most people confine their portfolio to just these two basic asset categories, thereby only getting rewards associated with those risks.
Alternative investments use other risk/reward strategies that could possibly enhance returns and create additional, more diversified return streams than just a stock and bond portfolio can provide, says John Micklitsch, CFA, director of wealth management at Ancora Advisors, LLC.
“For a long time, these strategies have been available mainly to institutional investors only in the form of hedge funds and private partnerships that have high minimums, lock-up periods and other associated nuances,” he says. “But increasingly, these alternatives strategies — and their alternative sources of potential return — are now being made available in liquid, public mutual funds, exchange-traded funds, or closed-end fund formats that are tradable and accessible to retail investors and smaller institutions alike. What this means for investors is the potential to build more diversified portfolios than ever before.”
Smart Business spoke with Micklitsch about liquid alternatives and how to take advantage of this diversifying vehicle.
How do you define liquid alternatives?
Liquid alternatives are, first and foremost, investments that are publicly traded and can be sold anytime, just like a stock or a mutual fund. That is the liquid side. Second, liquid alternatives are investment strategies that have the potential to diversify portfolios beyond just what holding stocks and bonds can do. So, liquid alternative investments are publicly traded investment funds offering daily liquidity and that deploy strategies beyond simply holding stocks or bonds. Some examples of alternative strategies that are now available in liquid form include: market neutral, long short, currency, commodities, managed futures, global macro, merger arbitrage, risk parity and short biased, to name a few. When included, these strategies have the potential to add significant diversification benefits to a stock- and bond-only portfolio, and therefore could be of interest to investors.
What is driving the increased number of alternative investment choices available to investors?
For a long time, large institutional investors have been investing in strategies beyond stocks and bonds to diversify their portfolios. Increasingly, the investment firms who manage these types of strategies have become interested in tapping into the retail (individual) and smaller institution investment space. They have accomplished this by opening up mutual funds with many of the same characteristics as their prized institutional alternative strategies. This trend should continue because coming off of the 2008 financial crisis, retail investors have become very interested in improving their overall portfolio diversification in an attempt to avoid the kind of volatility they experienced during the crisis. Liquid alternatives can play a role in accomplishing that.
What role do they play in an investor’s portfolio?
These strategies can act like shock absorbers to a traditional stock- and bond-only portfolio, in the sense that they can dampen volatility by improving overall diversification. They also have the potential to enhance realized returns because with a less volatile portfolio, investors are more likely to stay the course with their investment plan over the long term. The end result over a substantial enough period of time — five to 10 years — should be a smoother, steadier march toward your goals.
What are some of the risks of these investments?
These strategies are getting a lot of attention and interest, and therefore are attracting a lot of new players. It is important to know the pedigree and capability of the firm launching this type of mutual fund. There is a real risk of inexperienced firms putting strategies out that may not achieve their objectives. You can mitigate this risk by working with an adviser who has a high-experience level in evaluating, monitoring and selecting alternative investments.
Another risk, if you want to put it that way, is the risk that your portfolio goes through a period of underperformance in an up market because these diversifying strategies do not keep pace. Investors forget about the need to diversify in a bull market and diversifying strategies go by the wayside. Greed takes over and fear becomes a distant memory. It is precisely at these moments that markets are at their most dangerous and when investors should be working with their advisers to evaluate their diversification strategies. So the risk becomes not sticking with it, suffering through the period of underperformance and then not getting the benefit when market conditions change.
How should investors interested in adding liquid alternative strategies to their portfolio go about it?
The benefits of liquid alternative strategies outweigh the risks, in our opinion, but the benefits are more likely to be realized if you work with an experienced adviser who is knowledgeable in this type of space. A reasonable fee for advice would be more than justified in helping you to select the proper liquid alternative investments for a portfolio. In addition, to get the true benefits of these diversifying strategies, investors should consider at least a 10 percent to 30 percent allocation within their portfolio depending on their goals, risk tolerance and objectives. Retail investors and smaller institutions have never had so many tools at their disposal to diversify their portfolios. The key is knowing how to use them, which ones to select and the proper portfolio weighting.
John Micklitsch, CFA, is the director of wealth management at Ancora Advisors, LLC, a SEC registered investment advisor. Reach him at (216) 593-5074 or email@example.com.
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The investment market has been rocky the past few years, and there is no indication that volatility is going to change any time soon.
But current market conditions make it an excellent time to invest in dividend-paying stocks, says Sonia Mintun, CFA, vice president with Ancora Advisors LLC.
“Given the historically low bond yield environment, dividend-paying stocks are an attractive alternative,” says Mintun. “Right now, you can assemble a portfolio of quality stocks with a yield of 3 to 3.5 percent, in comparison to the 10-year Treasury yield of approximately 2 percent. Dividend-paying stocks also offer downside protection, providing a cushion during negative equity markets, while also allowing for the capture of upside potential.”
Smart Business spoke with Mintun about why dividend-paying stocks are a smart investment in today’s economy.
Why does dividend-oriented investing make sense in today’s markets?
There are several reasons: Dividend-paying stocks are less volatile than non-payers and they have been proven to have a lower standard deviation, which is a measure of risk. Dividends have accounted for 40 percent of total returns in the market since 1940, and dividend-paying stocks have outperformed non-dividend-paying stocks over the last 80 years. These stocks tend to be relatively stable over time because dividends are a component of earnings that are less subject to speculation. In addition, dividends are sticky, and tend not to fall, as companies are reluctant to cut them. Dividends allow investors to collect some income while they’re waiting for the fundamentals of the company to improve.
Furthermore, payout ratios are hovering at extremely low levels historically. They tend to revert to the mean over periods of two to three years. The current payout ratio is 30 percent, compared to a historical rate of 52 percent. With increased confidence and economic stabilization, we will likely see deployment of large cash balances on companies’ balance sheets toward higher payouts.
Dividend yields are also below long-term averages of 2.8 percent. Currently, yields are about 2 percent, despite cash balances being at record highs. Moreover, earnings are recovering from the financial crisis and balance sheets are healthy, so there is good potential over the next year or two that yields will rise due to increased payout ratios.
Last, given today’s bond yields, the S&P earnings yield — which is the inverse of the price/earnings ratio — is pretty attractive relative to the 10-year Treasury on a historical basis.
How does inflation impact dividend-paying stocks?
Historically, dividends have grown faster than the rate of inflation in the U.S. With 3 percent inflation now, short-term, high-quality, fixed-income instruments are losing purchasing power. You can get a 3 or 3.5 percent dividend yield on a diversified portfolio of good quality stocks, and have potential for income growth relative to the fixed coupon on bonds.
The average dividend income from a portfolio of S&P indexed stocks has grown at a rate of 5 percent per year since inception in 1957, which is one full percentage point over the rate of inflation in the same time period. As a result, dividend stocks offer both the potential for capital appreciation and income growth. Dividends increased more than 10 percent in 2011, on top of a 10 percent gain in 2010. Also, dividend-paying stocks have outperformed more often in higher inflationary times.
What vehicles can be used to implement a dividend-paying strategy?
Investors can buy individual equities in portfolios that are sizable enough to diversify the risk of one particular issue or sector. While dividend-paying stocks tend to be less volatile, it’s prudent to make sure your portfolio is not too concentrated in one sector or company.
Investors can also buy exchange traded funds, or ETFs, that concentrate on dividend-paying stocks. ETFs are a cost-effective way to invest in dividend payers while achieving diversification in smaller accounts. There are also mutual funds that focus on dividend-paying companies. These typically have higher expense ratios than exchange traded funds, but the fund manager can trade them more tactically than ETFs, which are passively managed and based on an index.
Are all dividend-paying stocks the same?
All dividend-paying stocks are not the same. It’s very important to do your homework on the company when you are buying individual stocks. Higher yield stocks are associated with better subsequent performance, but only to a degree. Those in the 3 to 6 percent dividend yield bucket have outperformed their peers, both those with higher dividend yields and those with lower yields.
Stocks with yields in the 6 to 9 percent range and above tend to have a higher standard deviation, or risk. Sometimes investors fall into the yield trap, buying troubled companies that cannot sustain high payouts, leading to cuts in their dividends.
Investors should seek stocks in which the dividend can be sustained, potentially evidenced by a low payout ratio and ample net cash or share buybacks. Look for companies that have consistent cash flow, a healthy balance sheet for their industry and that increase their dividends consistently.
Given today’s historically low bond yields, the potential for inflation down the road, as well as the other reasons I detailed, investing in dividend-paying stocks makes sense. With the expectation that volatility is going to continue due to our upcoming election and events in Europe, investing in less volatile stocks paying dividends is a sound strategy. Furthermore, based on price/earnings ratios and the potential for improving earnings, the disparity between the earnings yield on the S&P relative to 10-year Treasury bonds make dividend stocks an attractive investment.