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Value Tilt Drove Dividend Fund Outperformance

In an environment of low-interest rates and expansionary fiscal and monetary policy, growth assets far exceeded value. But the script has now flipped.

Michael Dobson 16 November, 2022 | 2:23AM
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Tilted blocks

Investors love income, traditionally supplied by bonds. However, in an era of low interest rates, dividend stocks, with their steady stream of cash, played the role of income provider to many portfolios. Retiree investors, for example, relied on frequent dividend distributions to deliver certainty to future spending plans.

For investors who want diversification, or lack the knowledge and skills to select stocks, mutual funds and exchange traded funds exist to deliver this income. An entire category of these styled funds exists to help investors identify these funds in the Canadian space named, aptly, the Canadian Dividend & Income Equity category. Unfortunately for these income investors, these funds fell behind their non-income-oriented peers for years; not that long ago, bonds yielded paltry interest and growth ruled the day. 2022 flipped the script with increasing rate hikes, geopolitical uncertainty, and a global economic slowdown. Retirees and income-seeking investors rejoiced as income funds far outperformed their peers, something not seen in the previous 5 years.

Exhibit 1

Side Note: Canadian Equity in this article looks at two Morningstar categories – Canadian Dividend & Income for income funds and Canadian Equity for non-income funds. Fund data used were from the oldest share classes.

Income investors had their cake and ate it too in 2022 – they enjoyed a lower drawdown and outperformed peers while doing so. In context, the average drawdown for income and non-income funds were minus 17.8% and minus 24%, respectively. To top it off, the average alpha generation was minus 3.6% for income funds and minus 13% for non-income funds. (Alpha a risk-adjusted performance statistic that’s used to evaluate how much value a manager has added over and above the return provided by the market over a specific time period – basically, outperformance over a benchmark)

Although the focus has been on 2022, a peek at the past 5 years' average drawdown and alpha generation shows that outperformance from income funds was no different, albeit not as pronounced; income funds experienced an average drawdown and alpha of minus 10% and minus 0.3%, while non-income funds had an average drawdown and alpha of minus 12.1% and minus 1.1%, respectively.

The Value-Tilt Paid Off for Canadian Income Funds

It is helpful to highlight some of the characteristics of income-oriented funds to understand how and why they outperformed non-income funds. While most Canadian mutual funds in the equity asset class display both value and growth characteristics, we found that a greater portion of income funds are value-oriented.

A value-oriented portfolio is characterized by holding a portfolio of established and stable companies, that usually have low turnover, long-term focus, and low volatility. Conversely, growth-oriented portfolios look for companies expected to grow their revenues and, in the long run, their profits, at a pace above the market.

Year-to-date through October 2022, on average we found that 32% of income funds have a value tilt while only 1% display a growth tilt. Conversely, only 12% of non-income funds have a value bias and 30% have a growth tilt.

A look at the sector allocations within Canadian Equity, US Equity, and Global Equity confirms this value-tilt and provides a more visible look at the drivers of outperformance.

Exhibit 2

How Did Sector Allocations Affect Performance?

Sector allocations can explain why this year income outperformed its peers and reflects the general value-tilt we observed earlier in income funds. At the start of the year, income-oriented funds held a higher weighting to energy, the best performing sector year-to-date, and lower weight to technology and consumer cyclicals, two of three worst performing sectors this year. These differences continued when viewing September 2022 holdings data as well.

Exhibit 3

Value vs. Growth: Who Wins?

Being value-oriented hasn’t always paid off for income funds. In an environment of low-interest rates and expansionary fiscal and monetary policy (like 2021), growth assets can far exceed value.

The last 10 years in the capital markets were an anomaly in history. Expansionary monetary policy kept interest rates low and near zero for a significant part of a decade which, in turn, caused investors to seek returns wherever they can be found. This led to a surge in flows to growth stocks and drove up valuation multiple which, by extension, resulted in the underperformance of income funds.

The proverbial low-interest rate linchpin propping up growth assets broke this year. Central banks confronted stubborn inflation which brought investors back to reality. Income funds benefitted through their more value-oriented approach while others fell behind, creating the spread we observe today.

However, investors should think long-term when making any investment decisions. Income funds, like any other, require patience to realize rewards over a full market cycle.

Abdulai Mohamed contributed to this article.

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About Author

Michael Dobson  Michael Dobson is an Associate Manager Research Analyst at Morningstar Canada

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