Diversifying Total Return Drivers

Equity ideas for 2020

Diversifying Total Return Drivers

Consumer stability and central banks may sustain the global expansion during 2020, but uncertainty lurks in persistent geopolitical issues.


The US equity market wrapped an incredible year with the S&P 500 Index up over 31%, the highest annual return since 2013. Most of these gains came in the fourth quarter of the year with US equities rising close to 9%. This sentiment has continued into 2020 despite heightened political uncertainty. While consumer stability and committed central banks will likely continue to sustain the global expansion during 2020, uncertainty lurks in persistent geopolitical issues.

The Case for a Strategic Low Volatility Allocation

Elevated economic policy uncertainty has reached its highest level in over two decades reflecting continued US-China conflict, an unfinished Brexit and the upcoming November 2020 Presidential election; however implied volatility as measured through the VIX remains at its lowest level since 2017. Is this divergence sustainable? At some point we believe volatility will rise as these measures typically converge over time. Similar to buying insurance, the best time to consider entering into a low volatility allocation is amidst low realized market volatility.

Extreme Divergence Between Political Uncertainty and Implied Volatility

Source: Bloomberg, 1997 – 2019. Global Economic Policy Uncertainty Index with Current Price GDP Weights. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

The Case for Income Appreciation

Equity markets have delivered remarkable returns in the decade since the Global Financial Crisis. Going forward, investors may face a decade of more modest returns given a starting point of elevated valuations, low interest rates and moderate economic growth. This provides a case for less reliance on capital appreciation and a greater effort to lock in total return through income. Cash flow diversification is one possible solution should investors face lower returns going forward.  Sectors such as Communication Services, Utilities and Real Estate source over half of their total return from dividends rather than capital appreciation.

Decomposition of Total Return

 % Dividend Contribution vs % of Capital Appreciation

Source: Bloomberg, Standard & Poor’s GICS Sector Classification. 25-Year Annualized Return proportion dividends vs capital appreciation contribute to overall total return as of December 31, 2019. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Maintaining dedicated strategic exposure to sectors with low historical betas, such as Utilities, Consumer Staples, Communication Services and Real Estate may serve to offset episodic volatility shocks while helping to lock in a greater proportion of total return through income.

10-year Historical Beta

Source: S&P 500, GICS Sector Classifications, eVestment.  Market beta relative to the S&P 500 Index over the 10-year trailing period ending December 31, 2019.Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Conclusion

The current market environment is an opportune time for investors to rebalance portfolios away from cyclical, high beta stocks, and diversify into defensively oriented sectors with stable sources of income which can lower overall volatility and provide additional sources of return amidst moderating economic growth.


Definitions:

Beta measures the sensitivity of an investment to the movement of its benchmark.  A beta higher than 1.0 indicates the investment has been more volatile than the benchmark and a beta of less than 1.0 indicates that the investment has been less volatile than the benchmark.

"Brexit" is a shorthand term referring to the UK vote to exit the European Union.

The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a measure of market expectations of near-term volatility as conveyed by S&P 500 stock index option prices.

The financial crisis of 2007–08, also known as the Great Financial Crisis, Global Financial Crisis and the 2008 financial crisis, was a severe worldwide economic crisis considered by many economists to have been the most serious financial crisis since the Great Depression of the 1930s, to which it is often compared.

The Global Economic Policy Uncertainty Index is a widely followed poll designed by three US economic professors, tracking the frequency of newspaper articles that contain a trio of terms pertaining to the economy, policy and uncertainty.  It can include broad economy-wide conditions and specific economic conditions of a particular industry.

Gross Domestic Product (“GDP”) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.

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Diversification does not guarantee a profit or protect against loss.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.