January Smorgasbord

Between the U.S. attack in Iran, the escalation of the Coronavirus, the lead up to the Brexit effective date, and the impeachment hearings, January was certainly chock full of potentially market moving events.  None of those events, however, stopped the S&P 500 from hitting new record highs in the middle of the month.  Unfortunately, the end of the month (especially the LAST DAY!) showed a retraction to erase all the gains of 2020! 

The positive factors of good economic growth, good corporate earnings and “easy” fed policy led capital market results before the markets eventually ceded to the culmination of all those foreboding events.  The risk of “uncertainty” is a strong behavioral bias that leads markets in the face of an otherwise positive fundamental situation.  Certainly, any one of those events could lead to a deteriorated market condition; put them together and you have a good recipe for “uncertainty soup!”

For every weak idiosyncratic stock story (e.g., ExxonMobil, Chevron, 3M, and Boeing), there seemed to be an equal and offsetting positive story (e.g., Amazon, Alphabet, Apple, IBM, and Tesla(!).

Likewise, there was a broad dispersion of broad asset class winners and losers during January.  The S&P 500 (IVV) ended January 2020 exactly unchanged, whereas utilities (XLU) and technology (XLK) held their returns being up 6.7% and 4.0%, respectively.  Factor positions such as momentum (MTUM) and low volatility (USMV), similarly, regained market leadership with respective returns of 3.7% and 2.4%.  High dividend stocks struggled to keep up with mostly neutral returns, whereas the most aggressive sectors of the global economy such as emerging markets (dealing with the China Coronavirus issue as “ground zero”) were down the most at -6%.

In the global capital markets that turned to “risk-off” at the end of January, fixed income assets regained favor with core bonds (SCHZ) being up 2%.  Investment grade corporate bonds (LQD) did better by recapturing their “rally hat” during January with returns of 2.5%.

During times of heightened market uncertainty, when there appears to be the creation of a market “inflection” point, there is often pressure to make a market call and go to “risk-off.”  It is my view that it is way too early for that view; but certainly anything can happen.  Alternatively, this is an excellent time to affirm your risk profile and be assured that you are exactly where you should be to achieve your goals. 

MAGA? 4 Trillion-dollar Companies!

I follow about 400 investment thought-leaders on Twitter.  One of them, Charlie Billelo from Compound Advisers, made an interesting observation today.  Namely, with the great price rally in Amazon (AMZN) today, there are now 4 stocks with a trillion-dollar market capitalization (share price times shares outstanding) and the tickers all spell out MAGA (Microsoft, Amazon, Alphabet (GOOGL), and Apple)!

I have commented before on this idiosyncrasy of a cap-weighted index (such as the S&P 500).  From my blog post back in October 2019, I noted that the top 10 stocks in the S&P 500 made up 22.1% of the index; today that percentage has grown to 23.6%.  It almost goes without saying that exposure in the S&P 500 is less diversified than otherwise; especially since there is a strong growth style and tech/communication sector bias – and even stronger tech bias if you include Amazon in that category!

As I said in October, and it is worth repeating today,  “Though it is nice to capture the “upside” of the large overweight to “growth” stocks, it will not be so nice to experience the downside risk that is sure to follow it someday; growth stocks tend to exhibit more volatility of return than the S&P 500.  Best to stay broadly diversified across all market sizes and characteristics to capture the inflection points when they occur.”

What Does AI Think of this Market?

As most readers of this blog know, I am a fan of some aspects of an artificial intelligence (AI) methodology to insulate portfolio management from behavioral biases.  One of my favorite vehicles for this is the AI Powered Equity ETF (AIEQ).  What are the portfolio holdings today and what can we learn from them?

I downloaded all the holdings from last night and see some interesting positions.  Some top holding names, like Alphabet (GOOGL), Amazon (AMZN) and Costco (COST), are expected, but others, like Estee Lauder (EL), are less expected.  Looking at all the other larger positions in AIEQ reminds me of the “Peter Lynch” investment approach of buying names that “you know and use everyday.”  The AIEQ list goes on to include Facebook, Mastercard, United Health, and Johnson & Johnson; certainly, household names!

From a top-down perspective, I was curious what investment factors are driving security selection? I used PortfolioVisualizer.com to calculate investment factor exposures in the current AIEQ portfolio.  For the four major factors being Size, Value, Momentum, and Quality, I was surprised to see only a small 0.32 bias favoring the small cap Size factor and almost no bias to Momentum, Value or Quality.  All of this while the AIEQ ETF produced a YTD total return of 4.43% beating the S&P 500 of 3.15%.  

The AIEQ investment approach is carefully guarded, but from these statistics it appears that factor analysis is not part of the formula.  From the AIEQ web site, the AI model is targeted to combine fundamental and technical methods to produce a better probability of capital appreciation at similar levels of risk of broad stock indices.

What's in a Name?

Identifying a client’s risk profile is the most important factor to consider before implementing an investment plan.  Items like client age, wealth, cash flow needs, etc. all come together to lead to a single answer to the amount of risk a client can tolerate.  But, what does it mean when it is determined that their risk profile is “moderate”?

Most of the answer settles on the asset allocation split between equities, fixed income and cash.  As we all know, equities are generally more risky than bonds and cash.  But, not all equities and bonds have the same amount of risk so we need to look further into the underlying characteristics.

For example, modeled historical measures of standard deviation of return (i.e., statistical measure of variability around the average return) and “drawdown” (i.e., peak to trough return volatility) are useful to help categorize the risk profile of a portfolio.

Being able to measure the underlying risk of a strategy is critical because simply saying “moderate” does not get you to a universally-accepted approach.  For example, I am aware of three funds that have the word “moderate” in their name but have very different approaches and risk profile.  Per the table below, you can see that large variation in return and risk.  So, though MAMAX has top returns, it also has top standard deviation of return and drawdown!  Interestingly, AOM with the lowest return has the highest amount of return per unit of risk (1.54).

So, best that any investment strategy includes a recognition of the underlying metrics supporting the risk profile and not just settle on a name!

Factors Matter!

The smart guys at Newfound Research highlighted a few key points from the 2019 market performance in their annual review.  A key one for me was the significant lag in “factor” performance, i.e., the academically-supported expected performance premium to be garnered from key underlying traits of stocks.  The major “factors” that underperformed were stocks with a high trait of value, size, momentum, and low volatility; only the quality factor was close to break-even versus the S&P 500.

They go on to say that periods like this are not a huge negative outlier.  But, what is huge is the fact that all of them underperformed at the same time during the same time horizon!

So, what is the lesson here?  My investment philosophy is grounded in a globally-diversified, multi-asset long term strategic approach to capture market returns and manage risk.  Exposures to the well-documented “factor” space is part of that viewpoint.  It is unrealistic to expect each and every asset allocation choice to outperform each and every period.  In fact, due to normal market volatility and a rotation of returns, I would not be surprised to see factors outperform core holdings in the future; we shall see!

Where's the Beef (data)?

From someone who grew up in the dark ages of IBM PC’s, floppy disks, and 28k modems for online access, we have certainly come a long way; especially as it relates to access to financial data.

I recently chatted with a colleague and we discussed sources of market information.  Bloomberg, of course, is the info giant for financial information; a one-stop online shop for almost everything financial with great analytics, but at a steep price!  However, they don’t have a monopoly on data and analytics and a lot of what they offer can be gotten for free on respected sites.  Following are a few of our favorite sources of data and analytics.

For raw data, Yahoo finance is a good first place to check.  One of my favorite features to help calculate total returns for stocks, mutual funds, or ETFS is the “Historical Data, Adj Close” data.  This data adjusts the price of the security for dividends paid so that a pure “total return” calculation can be done; very useful to track performance between two dates that aren’t on an even month- or quarter-end.  Simply divide the ending value by the beginning value to get a total return including price and income return.

The “Chart” feature on Yahoo Finance is also very robust.  It allows price charting for custom date ranges with comparison to additional securities.

For pure raw data with a focus on economics, you can not beat the FRED site sponsored by the Federal Reserve Bank of St. Louis.  They have populated all the official data for all the economic statistics you could ever need into a handy online interface.  Data series like official historical inflation, GDP, and industrial production, as well as financial data like credit spreads, yield rates, and S&P 500 are all there and easily accessible.  In fact, it includes access to over 500,000 financial and economic data series (who knew there were that many!!)

I have a few other favorite sites that focus on analytics I will post next week.

Q4 Caps Super 2019

The markets love a dovish Fed and that is what it got in 2019.  Going into 2019, there was a prospect of higher rates that was quickly squashed by a data-dependent Fed that cited potential economic weaknesses here and abroad.  The Fed reversed course and pointed to lower rates.  Easing of global trade concerns helped, too!  The S&P 500 responded accordingly with a stellar 2019 total return of 31.49% (including dividends), the strongest annual performance since 2013.  Q4 showed a continuation of the trends set up earlier in the year with equities extending their gains and bonds showing some weakness due to yield curve steepening.

The equity rally was broadly based with some relative winners and laggards.  During Q4, large- and small-cap equities represented by the S&P 500 (IVV) and the DJ U.S. Small Cap Total Market Index (SCHA) were strong performers with both being up about 9%, while mid-cap (SCHM) lagged at 7%.  Factor plays, that are expected to outperform over a full market cycle, also lagged in Q4 with momentum (MTUM) and low vol (USMV) producing returns of 5.72% and 2.95%.   Real estate investment trusts (SCHH) gave back some of its big gains earned earlier in the year with Q4 returns of -1.95%.  Finally, of all the major broad asset classes, emerging market equities (IEMG) led all markets in Q4 with a 12.18% return.

Fixed income markets were less bullish in Q4 due to the yield curve steepening prompted by Fed easing and the market taking long rates higher.  Core bonds (SCHZ) were mostly flat with a Q4 return of 0.10%.  Bonds with some credit spread were the winners in Q4 with emerging market bonds (EMB) and high yield bonds (HYG) leading the pack with returns of 2.56% and 2.48%.  Likewise, short bank loans (BKLN) with some credit spread improved with a 2.20% return.

So, will this trend continue?  Most of the indicators I follow point to a bullish “risk-on” sentiment for the near term.  But, as I reported in my Dec. 1 blog post, “My Favorite Chart”:

Fans of “reversion to the mean” will be anxiously awaiting the S&P 500 retraction whereas “momentum” players are looking for more gains.  We shall see; best to stay well-diversified in a portfolio managed to your appropriate risk-profile.

20/20 Foresight?

Former Fed Chairman Alan Greenspan was quite opinionated on our ability to forecast capital markets.  He is known to state that we aren’t very good at forecasting, but we have no choice but to forecast since every position we take implies a forecast.  He even goes so far as to say that a forecast, by virtue of its presence, changes the environment such that it creates an arbitrage situation impacting the forecast.

The previous thoughts notwithstanding, this is the time of year when all the investment thought leaders put out their forecasts for the coming year.  It is always interesting to see what themes emerge and to parse out the nuggets that stand out.  I am always fascinated about how wrong these forecasts can be, however.  For example, the Wall Street Journal last year famously showed a survey of economists where EACH AND EVERY ONE “wrongly” predicted higher rates in 2019 (see my previous blog post here: https://www.dattilioash.com/our-blog/2019/6/13/interest-rate-forecast-foible).

This year, Wells Fargo Investment Institute came out with their fairly modest view for 2020.  Following is a table of the big highlights:

You can read the full report yourself here, if interested: https://d2fa1rtq5g6o80.cloudfront.net/wp-content/uploads/2019/11/6600703_WIM-CM_Q3_WFII-2020-Outlook-Report-Paper_A1_F1_a11y_reduced.pdf. 

It is good reading and tells a good story, but will 2020 play out as forecast and produce good capital market returns?  As I have re-counted before, “Beats Me!”  But, I will be watching closely!

A No-Tax Situation

Most investors are aware of tax loss selling, i.e., sheltering income by selling securities at a loss to reduce taxable income in a calendar year. However, there is another situation where selling securities at a “gain” is equally advantageous. For investors filing as an individual with taxable income under $39,375 (or other income limits for different filing categories), the federal tax rate on long term capital gains is 0%!

Selling securities at a gain in a taxable account with no tax liability is very attractive economically. Granted, you need to have low taxable income to qualify, but there are many reasons why a person could be in this situation. For example, you could be a young person with some savings in a taxable account just starting a career with an entry-level pay scale with more earning potential in the future. Or, you could be a retired worker with lots of savings in a taxable account, but not much income in any given year (for example, before you elect to begin social security payments).

Regardless of your specific situation, it is always beneficial to consider this feature of the federal tax code to see if it saves you taxes. The net result of this activity is to increase your cost basis for tax purposes. For example, let’s assume you have a position in an S&P index fund with a $10,000 unrealized gain. Selling that position and reinvesting into another similar-type investment increases your tax cost basis, thus completely eliminating your embedded tax liability that could be a factor in future tax years; perhaps when you have taxable income over the limit and would be liable for a tax payment.

There are a few other things to consider, of course. For example, there may still be a state or local tax liability that needs to be paid. Or, if the investor is claimed as a dependent there could be a kiddie tax consideration. It is best to consult with a tax adviser who can give a complete analysis and recommendation in support of this tax management strategy.

Nice November

Like October, November offered plenty of geopolitical intrigue with ongoing dialogue on China trade, impeachment inquiries, and comforting Fed-speak, but the combination of all these countervailing forces prompted strong equity markets.  The S&P 500 kept up its torrid pace setting new all-time highs, while other equities tried to keep up.  In the fixed income space, core bonds were mostly flat, while bonds with some credit risk posted modest positive returns.

The S&P 500, with its huge weighting of 22% to just 10 stocks, returned +3.64% for the month.  Other core equity plays like small cap (SCHA) and mid cap (SCHM) also performed well with returns of 3.92% and 3.88%, respectively.  Action in the “factor” space of momentum and low vol spent another month with modest lagging returns of 3.29% and 1.39%, respectively.  An “AI-managed” ETF (AIEQ) insulated from behavioral biases, pulled out another winning month with a 4.96% return for the month and YTD S&P 500-beating returns of 28.46% (versus 27.52% for the S&P).  High div plays mostly lagged a bit, but rising dividend yields portend higher returns in the future if market rates stay low or go lower; same goes for REITs.

The bond market, taking a breather from its scorching pace through September, stayed calm with some pockets of positive return.  Core bonds (SCHZ) were mildly negative with a -0.09% returns while bonds with credit risk like investment grade corporates (LQD), high yield (HYG), and bank loans (BKLN) gave positive returns of 0.47%, 0.57% and 0.61% respectively.   

Tactical players in the asset allocation space struggled during the month.  The Morningstar Tactical Allocation Category produced an average return of 1.41% for the month, while one notable asset allocator, the Cambria Global Momentum ETF (GMOM) earned negative returns for the month of -0.46%.  Just another indication of how “smart” money can be wrong!

One month is never enough time to gauge the effectiveness of a long-term strategic investment strategy.  These monthly checkpoints let us gauge the individual winners and losers.  We don’t expect each investment to outperform each and every month; but, instead are looking for a positive gap for the whole portfolio of investments over a full market cycle.

My Favorite Chart

This chart is one of my favorites.  It maps the performance of the S&P 500 (SPY) versus the Aggregate Bond Index (AGG) and other risk-managed portfolios from Conservative to Aggressive (Dow Jones Portfolio Indices).

I updated the chart though October 2019 to reflect the extraordinary market recovery from the depths of Q4 2018.  I like this chart for mostly one reason; it shows the dramatic trade-off between risk and return.

The solid black line shows the path of the S&P 500 (SPY); very choppy and subject to big drawdowns and big recoveries.  The Aggregate Bond Index (AGG) is the mostly flat green line.  Each of the risk-managed portfolios of global stocks and bonds occupy the space between those boundaries; ordered appropriately with the most risk outpacing the lessor risk.

It is interesting to note that the Aggregate Bond Index actually outperformed the S&P 500 from 2008 through 2013; and then fell woefully behind since then.  The S&P 500 since 2013 has been on a tear widening its outperformance to the risk-managed portfolios with each subsequent month.

Fans of “reversion to the mean” will be anxiously awaiting the S&P 500 retraction whereas “momentum” players are looking for more gains.  We shall see; best to stay well-diversified in a portfolio managed to your appropriate risk-profile.

The Trouble with Tactical: Part 2

As readers of this blog may know, I have a bias against high-fee active investment management due to the academic research that shows persistent underperformance against benchmarks.  This is not to say that some active managers don’t beat the market, since some do – it is just that you can’t tell ahead of time which manager is going to lead the pack!

An extreme case of active management is in the pure tactical space; that is, those managers who take bets on equity and bond allocations to pick off tops and bottoms in the market.

My blog post from January and February of this year highlighted the performance and asset allocation positioning of the tactical Cambria Global Momentum ETF (GMOM); a fund that takes allocation bets based on momentum.  At that time the fund was weighted 30% in equity, 7% in precious metals with the balance in short bond ETFs.  Interestingly, its current asset mix as of Nov. 30 is still heavily weighted to fixed income with a 70% allocation, despite the S&P 500 hitting new all-time highs in November.

As expected, performance has lagged this year.  Through Nov. 30 the GMOM fund is up only 6.2% with the S&P 500 up 27%.  The whole tactical space as represented by the Tactical Allocation Morningstar Category did better at up +11.4%, but still lagged a naïve benchmark approach by a wide margin.

Those investors who looked to pick off some extra return versus the S&P 500 by being “tactical” gave up some outsized gains this year.  Best to stay the course in a well-diversified long term strategic global portfolio managed to your appropriate risk profile.

A Bit More on Active versus Passive

The following info is purely anecdotal and unscientific, but a useful bit nonetheless.

I have access to a major corporate 401-k retirement plan that has 17 active and passive fund choices; some of the active funds have an equivalent passive fund alternative.

Per the table below, this is how some of the active funds performed compared to their equivalent passive funds.  Not surprisingly, each of the active funds underperformed their passive counterpart; some by a wide margin.  Not sure if this relationship can persist, but the evidence keeps piling up in favor of passive.

A View on Negative Interest Rates

Early in my career I worked at an insurance company on the development of a new computerized investment administration and accounting system.  One of the things we had to deal with was how to handle a new asset class: zero coupon bonds, or bonds that did not pay cash interest, but instead sold at a deep discount and matured at par value.  In the current post-Credit Crisis environment, we have had a more unusual investment to deal with; bonds that “pay” negative interest rates!

Wells Fargo recently published their strategic view of how to invest in this current negative interest rate world (“Living in a Negative Interest-Rate World”, October 31, 2019).  In it, they describe the global causes, potential for it to spread to the U.S. market, and investment implications.

As seen from the chart here, this situation has grown too big to ignore.  Starting in late 2014, the volume of this debt has grown currently to over $17 trillion (though it has pulled back a bit from that top)!  The causes came from global central banks easing monetary policy through quantitative measures to help avoid a recurrence into another deep recession.  However, the jury is still out on whether this approach will ultimately prove successful!

 The U.S. bond market currently has positive rates and does not seem positioned to enter that market realm.  The authors quote some reasons, including: the U.S. has not shown a tendency toward deflation, the U.S. dollar’s dominance helps fend off negative interest rates in the U.S., and the Fed does not clearly have statutory authority to set negative interest rates.

The paper cites a few ways to invest for this market environment.  Obviously, dividend-paying equities have been a prime example of an investment alternative.  Also, bonds with some credit spread, preferred stocks, and emerging market debt can offer good value.  However, as always, it is critical to remain well-diversified and invested to your strategic risk tolerance.

More Bad News for Active Managers

The S&P Indices Versus Active (“SPIVA”) report came out today with its semi-annual update as of June 30, 2019. Perhaps to no one’s surprise, the trends uncovered from the SPIVA reporting over the last 17 years have continued.

As reported by SPIVA, “For the one-year period ended in June 2019, 71% of domestic equity funds underperformed the S&P Composite 1500, slightly more than the previous report’s 69%.” However, in a turn for the better, over this same time horizon most mid- and small-growth managers beat their respective benchmarks with 88% and 85% scores, respectively. However, the authors point to a potential problem in the data that they termed “size creep”, where small- and mid-cap managers have resorted to buy large-cap securities to help boost returns (something the indexes do not do).

Over longer term horizons including 5-, 10-, and 15-years, the results have barely budged with over 80% of active managers underperforming their benchmarks.

Likewise, fixed income investing was no exception. The report said, “The majority of fixed income active funds underperformed their benchmarks with global income funds (at 44%) the lone exception.” Also, aside from Investment-grade Intermediate funds with a 50.5% score, the balance of the taxable categories logged scores of over 80% underperfomance. This seems to defy the notion that active bond managers have a better chance at outperforming their indices since their market is more diverse and opaque and more suited to better positioning than a naive cap-weighted index.

Finally, the Great Rotation?

Many thought leaders have prophesied the Great Rotation, i.e. the relative value asset allocation shift from bonds into stocks, ever since the economy started to recover after the Credit Crisis in 2008/09.  All of those calls have been false starts since bonds continued their decades-long bull market through this September.

However, there is no denying that the total return profiles for stocks versus bonds have been quite dramatic since September 30.

As seen from the chart below, the S&P 500 has continued it tear into record territory while core bonds and other fixed income sub-sectors have given back some of the extraordinary gains earned during the first part of 2019.  The S&P 500 is up just about 4% since then, but most bond classes are clustered being modestly negative to flat over that time horizon.

There are plenty of countervailing economic and capital market forces supporting this rotation.  The most impactful force may simply be the easing of trade tensions (though nothing is signed yet) that could support stronger global economic growth (and increased inflationary expectations) causing longer term bond rates to rise while improved economies support higher corporate earnings growth leading to higher stock prices. 

It is not (is never!) clear if there is enough underlying strength for this trend to continue; we will all know if it turned out to be THE inflection point sometime in the future.  In the meantime, as mostly always, best to stay the course with a well-diversified risk-appropriate strategy.

New Fee Table Regulation for MA

Clients of investment advisers registered with Massachusetts should be prepared to start seeing a new regulatory document.  Beginning on January 1, 2020, Massachusetts investment advisory firms are required to provide a stand-alone fee table document highlighting all fees that clients can expect to be charged.  

The new stand-alone fee table will  be provided to all new and potential clients of the adviser, as well as provided to existing clients on an annual basis and whenever the table is updated.  It will also be required to be posted on the adviser’s web site. There is no new information on the table; it is simply a re-formatted carve-out of existing material contained in the Form ADV Part 2 Items 4 and 5.

The federal regulator, the U.S. Securities and Exchange Commission (SEC), and no other state requires this so it is unique to Massachusetts.  The form is designed as a template for all advisory forms to fill out.  Because it is a template, it should be easy to compare Massachusetts advisers with each other, but not so easy to compare with SEC-registered or other state-registered advisers.  Interestingly, for advisers registered in Massachusetts with a principal place of business outside of Massachusetts, the table is only required for clients who are Massachusetts residents.

Odd October

October 2019 was an odd month for the capital markets.  The S&P 500 produced another all-time high and generated a 2.2% total return (IVV) for the month, but some of the other stellar performers during the year lagged while other surged.  Let’s look at each of the major sectors that deviated from the norm.

High dividend stocks have been strong performers since the Great Recession in 2008/2009 mostly matching the 10-yr total return of the S&P 500, but generating much more income that is a positive trait for investors looking for spendable income.  However, the return profile has not been smooth as YTD performance in 2019 has been lackluster with some lags.  October is no exception with many of the major high dividend ETFs lagging the S&P.

Likewise, previous YTD stars in the equity space like factor exposures in low volatility and momentum took a breather from outperformance in October.  The USMV and MTUM ETFs from iShares representing min vol and momentum lagged the S&P 500 in October with total returns of -0.23% and 0.65%, respectively.

Meanwhile, developed and emerging market equities represented by SCHF and SCHE took a shot at catching up with the U.S. market with some material outperformance with respective monthly returns in October of 3.14% and 5.33%

In the fixed income arena we saw some normalization of returns that were outsized during the first three quarters of 2019.  Unless the U.S. were to follow the majority of the developed world into negative rate territory, bonds had to give back its extraordinary YTD gains earned prior to Sept.  Such was the case in October as all sectors in the fixed income space produced flat to negative returns.

The capital markets are dynamic and sector leadership will constantly rotate as fundamental, technical and behavioral factors play out.  It is not reasonable for long term strategic expectations to play out each and every month, quarter, or even year.   

Investments 101: The Trouble with "Cap-weighting"

The S&P 500 index is the most popular large capitalization stock index in the U.S.  It includes the 500 largest stocks in the U.S. and is diversified across a broad cross-section of different industries.  It is a “capitalization-weighted” index, meaning the composition mix of stocks is weighted by the market capitalization of each stock in the index.  For example, Microsoft (MSFT) currently has a market cap of over $1 trillion dollars (equaling its current share market price times its current shares outstanding).  This huge market cap influences its weighting in the S&P 500 index; it currently has a weighting in the S&P 500 index of just over 4%!

In fact, there are many other “mega-cap” stocks that also hold a large position in the S&P 500 index.  Other large names include Apple, Alphabet, Amazon, Facebook, Berkshire Hathaway, JP Morgan, Johnson & Johnson, and Procter & Gamble; mostly stocks with a “growth” bias.  The top 10 holdings in the S&P 500 make up 22.1% of the index.

To the extent that these largest stocks in the index perform either well or poorly will impact the results of the index disproportionately.  Over the last three years, “large growth” stocks have had a great run as shown by their 16.0% compound annual return on the chart below (shown by the growth ETF, IVW) compared to the S&P 500 return of 14.1% (SPY) and the S&P 500 on an “equal-weighted” basis return of 11.8% (shown by the equal-weighted ETF, RSP, where each stock in the index holds a 1/500th weighting).

Though it is nice to capture the “upside” of the large overweight to “growth” stocks, it will not be so nice to experience the downside risk that is sure to follow it someday; growth stocks tend to exhibit more volatility of return than the S&P 500.  Best to stay broadly diversified across all market sizes and characteristics to capture the inflection points when they occur.

Investments 101: Price vs. Income Return

There are two components of total return: price and income.  Price return is the change in price from the beginning to the end of a period.  Income return is the amount of income generated from the beginning to the end of the period.  Total return is the combination of price and income return.

For an example, let’s consider the iShares Select Dividend exchange-traded fund (ETF)(DVY).  Per the chart below, over the last year ended October 18, 2019, DVY produced a total return of 7.9% and a price return of 4.1%; leaving the income return to be 3.8%.  What does this mean and why does it matter?

Retirees often look to their investment portfolio to generate some “spendable” income to supplement pensions, annuities, or social security benefits.  Income return is paid in cash and can be used to pay for ongoing expenses or financial goals.  Price return can also be used as spendable cash, but that involves selling shares to realize gains (hopefully!); and that is the problem!  Since no one knows when price return may be up or down, there is the risk that share price is down when you are selling; of course, not a good thing!

Different asset classes have different price/income return profiles.  For example, as in the DVY example above, equity (stock) investments tend to have higher price return compared to income return.  Bonds, on the other hand, generally have a larger income component.  There are times, however, when the income return from equities is HIGHER than for some classes of bonds (as it is now!)  This is a period of time where high dividend-paying stock investments are especially attractive compared to bonds.

For an investor with a need for an income-focused investment strategy, it is important to understand the specific underlying characteristics of the asset classes to be sure they are carefully selected and weighted to provide the appropriate mix for the investor.

For the investor who decides to spend the income component, it works out very well that the price component is still generating price return (hopefully positive over time).