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Equity Income: A source of added value

Five years have passed since the launch of GAM Investments’ global equity income strategy. While half a decade is not a particularly long period of time, it nevertheless represents an opportunity to discuss the viability of the investment case in light of the current investment conditions. Do global equity income strategies (ie investments in companies with above average shareholder yields - through dividends and/or share buy-backs - financed by reasonably good business models) make sense in general? Or is it simply the case that they have benefited from falling bond yields and a reversal in this secular trend will spoil the party?

Tuesday, April 24, 2018

A globally unique definition of the meaning of global equity income does not exist, but one way to analyse the effectiveness of this investment approach is to compare a global high dividend yield and a global high quality index with a plain vanilla global equity index (see chart 1). Based on MSCI indices since the end of November 1998 both styles added value in comparison to the global equity index, albeit not at the same point in time. The high dividend yield index has struggled to keep up with the world index since the first quarter of 2007, while the global quality index has clearly outperformed over the same timeframe.

Chart 1:

MSCI World High Dividend Yield and MSCI Quality Index vs. MSCI World Index
(Gross Dividends reinvested)

Equity Income A source of added value Chart 1

Source: Bloomberg. Period analysed 31.12.1998 to 28.02.2018. Past performance is not an indicator of future performance and current or future trends.

As a consequence, data covering the previous 20 years, clearly demonstrates that a combination of the two styles in the form of a global equity income investment approach has the potential to add value relative to a plan vanilla global equity index.

How do interest rates come in to the picture? A hint can be taken from chart 1 during the period from 2003 to 2007 where the relative performance of the high dividend yield and the quality strategy diverged materially while bond yields initially marked time and then started to rise. This performance pattern, i.e. the relatively high likelihood of the outperformance of value and the underperformance of growth in periods of rising interest rates is also backed by academic research.

But what can be stated in relation to the relative performance does not necessarily reflect the absolute performance picture. Chart 2 illustrates the absolute return of the global high dividend and the global sector neutral quality index in USD in combination with the development of the JP Morgan global government bond index.

Chart 2:

JP Morgan Global Government Bond Yield vs. MSCI World High Dividend Yield and MSCI High Quality Index
(Gross Dividends reinvested)

Equity Income A source of added value Chart 2

Source: Bloomberg. Period analysed 31.12.1998 to 28.02.2018. Past performance is not an indicator of future performance and current or future trends.

Rising interest rates potentially reduce equity returns but that does not necessarily imply negative performance. For instance, US equities generated a return of 6.9% p.a. from 1962 to 1981 while 10- year government bond yields rose from 4.1% to 14.0%1. Conversely, since 1982 bond yields have declined while average equity returns climbed to 11.7%2 p.a. In addition, chart 2 shows two shorter periods of slightly rising bond yields in combination with rising equity market indices from 2003 to 2007 as well as during the period from mid-2016 to date. Negative equity returns usually arise as a result of adverse earnings surprises at the end of a protracted period of rising interest rates, rather than occurring during the hiking cycle itself.

Overall one can state, that equity income strategies still make sense even in an environment of rising interest rates, but the composition of the portfolio needs to adapt to the shift in financial conditions. This emphasises the importance of adopting an active stance in order to generate optimal returns from such an approach and we look forward to generating further value on behalf of our investors over the next five years and beyond.

1. Source: Bloomberg. Period analysed 31.01.1962 to 31.12.1981. The S&P 500 total return index (gross income reinvested) has been used as a proxy for US equities. 2. Period analysed 31.12.1981 to 28.02.2018.
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