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How Much Will My Retirement Income Cost? Part 2

Evaluating Various Financial Ratios Used in Dividend Analysis

Where May Equities Go From Here?

Considering REIT Lease Durations in a Rising Rate Environment

Laddered Protection

How Much Will My Retirement Income Cost? Part 2

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Wes Crill

Vice President, Research

Dimensional Fund Advisors

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Understanding how much future spending, or consumption, an investor’s savings can support is critical in planning for retirement. As we discussed in part 1, the S&P STRIDE Index Series can help by providing a framework for estimating the annual income stream available in retirement using the concept of the Generalized Retirement Income Liability or “GRIL” (see part 1 for further details about the GRIL). Another integral factor in planning for retirement is selecting the right investment solution.

An investment solution integrated with the goal of retirement income should focus on reducing volatility in the ratio of account balance to cost of income, which reduces uncertainty in the income estimate. From an investment strategy standpoint, that implies designing a solution that tracks the cost of income so that our account balance moves in tandem with it. This type of strategy is called a liability-driven investment, or LDI,[i] and has long been used by defined benefit plans to align their assets with their liabilities.

As we explained in part 1, the two primary risks which impact account balance and the cost of income are interest rates and inflation. The S&P STRIDE Index Series are designed around retirement dates in five-year increments from 2005 (current retirees) through 2060. Each index includes an LDI component—inflation-protected fixed income securities with an average duration[ii] matching the expected timing of the retirement cash flows for that specific retirement period. This approach provides more comprehensive management of the risks that add uncertainty about future income.

As Exhibit 2 shows, the LDI strategy dramatically reduces the volatility in estimated income compared to intermediate bonds and T-bills (which often constitute the risk management assets in retirement-focused investment solutions). The S&P STRIDE LDI component is designed to approximate the sensitivity of the cost of income to interest rates and inflation, so even as the account balance changes, the estimated retirement income is steady over time. In contrast, the values of the shorter-term bonds – represented by the US Aggregate Bond Index and the one-month T-bills – are less sensitive than the cost of income to interest rates and inflation. Even though the account balance changes less over time with those investments, the estimated income is more volatile because the account balance is not moving in tandem with the cost of income.

Successful retirement planning means more than just saving and must take into account the decumulation phase.[iii] Doing so effectively requires information about how much an investor’s savings can provide in terms of retirement income. Obtaining relevant information about this goal is best accomplished using a framework that integrates the investment solution with the risks that produce uncertainty in translating account balances into estimated future income. The S&P STRIDE Indices provide a measure of the cost of income, the GRIL, and allow for the calculation of how much retirement income can be generated from a given level of savings. Using this measure, we can then create an investment strategy that reduces retirement income uncertainty to help investors better plan for retirement and pursue better retirement outcomes.

 

[i] A liability-driven investment (LDI) strategy is designed to focus on assets that match future liabilities. LDI strategies contain certain risks that prospective investors should evaluate and understand prior to making a decision to invest. These risks may include, but are not limited to, interest rate risk, counterparty risk, liquidity risk and leverage risk.

[ii] Duration is a measurement of the sensitivity of the price of a fixed income investment to changes in interest rates. Generally, high-duration bonds will have greater sensitivity to changing interest rates than lower-duration bonds.

[iii] The decumulation phase refers to the period after retirement, where retirees draw down on or ‘decumulate’ their retirement savings.

 

Important Information

The S&P STRIDE Glide Path 2020 Index (the “Index”) was launched on January 11, 2016. All information presented prior to the Index launch date is backtested. Backtested performance is not actual performance, but is hypothetical and is generally prepared with the benefit of hindsight. Backtested information reflects the application of the Index methodology and selection of Index constituents in hindsight. No hypothetical record can completely account for the impact of financial risk in actual trading. For example, there are numerous factors related to the equities, fixed income, or commodities markets in general that cannot be, and have not been, accounted for in the preparation of the Index information set forth, all of which can affect actual performance. The backtest calculations are based on the same methodology that was in effect when the Index was officially launched. Complete index methodology details are available at www.spdji.com. It is not possible to invest directly in an index.

Index Series Description

The S&P Shift to Retirement Income and Decumulation (STRIDE) Index Series comprises 12 multi-asset class indices, each corresponding to a particular target retirement date. The asset allocation for each index in the series is based on a predetermined life-cycle glide path. Each index reflects a multi-asset class solution, with varying levels of exposure to equities, nominal fixed income securities, and inflation-adjusted bonds.

The S&P STRIDE Index Series represents a strategy that builds a portfolio of assets to support a hedged stream of inflation-adjusted retirement income. The indices also provide a new framework for benchmarking target date funds (TDFs) that focus on delivering similar results. The indices are individually composed of asset class indices (an index of indices), and the index series includes target date years in five-year increments (vintages). Each index vintage covers a full life cycle of accumulation (during what are generally considered working years) and decumulation in retirement years. Beginning 20 years before each target date, the indices gradually re-allocate some of their weight from accumulation constituents to inflation-adjusted income constituents. This process is analogous to dollar cost averaging into income-producing assets. The income portion consists of a duration-hedged combination of Treasury Inflation Protection Securities (TIPS) indices. The duration of the combined TIPS indices is matched monthly to the duration of a hypothetical retirement income cash flow stream that begins at the target date and lasts for 25 years.

The S&P STRIDE 2020 LDI Component represents the component of the S&P STRIDE Glide Path 2020 Index, which is the income-risk management allocation—made up of underlying S&P TIPS indices held to the same proportions as the S&P STRIDE Glide Path 2020 Index.

Exhibit 2 Data Methodology

Exhibit 2 shows retirement income estimates over time for a 2020 retiree; the estimates are in terms of annual retirement income in January 2003 dollars, assuming 25 years of income starting in 2020 and a $200,000 initial balance in January 2003. The income estimates are shown for three different investment strategies, represented by the S&P STRIDE LDI Component, S&P US Aggregate Bond Index, and one-month T-bills. Income estimates are calculated by dividing the account balance (including the initial $200,000 and investment returns) by the GRIL at a particular point in time for a particular investment strategy, and then adjusting back to January 2003 dollars using CPI.

For example, to calculate the income estimate for January 2010 under the S&P STRIDE LDI Component strategy, we first calculate that the beginning balance of $200,000 would have hypothetically grown to $315,550 by January 2010. The GRIL in January 2010 was 16.0127, so by dividing the hypothetically grown balance by the GRIL, we calculate an estimated annual retirement income stream starting in 2020 of $19,706 for 25 years. Using the CPI to adjust this back to January 2003 dollars, this amounts to an estimated annual retirement income stream starting in 2020 of $16,524.41 for 25 years.

Disclosures

The S&P STRIDE INDEX is a product of S&P Dow Jones Indices LLC or its affiliates (“SPDJI”) and has been licensed for use by Dimensional Fund Advisors LP (“Dimensional”). Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by Dimensional. Dimensional’s products, as defined by Dimensional from time to time, are not sponsored, endorsed, sold, or promoted by SPDJI, S&P, Dow Jones, or their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such products nor do they have any liability for any errors, omissions, or interruptions of the S&P STRIDE Index.

Dimensional Fund Advisors LP receives compensation from S&P Dow Jones Indices in connection with licensing rights to the S&P STRIDE Indices. It is not possible to invest in an index.

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Evaluating Various Financial Ratios Used in Dividend Analysis

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Qing Li

Director, Global Research & Design

S&P Dow Jones Indices

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There are many ratios that are used to assess the strength of dividends. In this blog, we explore the commonly used dividend measures in income analysis and their applications. We also introduce cash-flow-based measurements, such as free cash flow yield, that can be combined with traditional dividend measurements to provide additional insight into the quality of dividends.

The most frequently used measure—dividend payout ratio, which is calculated as dividend per share divided by earnings per share—shows what percentage of its profit a company is returning to its shareholders in the form of cash dividends. A low dividend payout ratio means that a company is returning a small portion of its earnings to investors, while a high payout ratio implies that a company uses the majority of its profit for dividends instead of for future growth.

Dividend coverage ratio tells the same story, with the exception that the ratio is calculated as the inverse of dividend payout ratio. Therefore, a low dividend payout ratio and a high dividend coverage ratio have the same indication for the quality of the dividend. Both dividend payout ratio and dividend coverage ratio can be paired up with dividend yield information to help evaluate a company’s dividend payment capabilities. For example, a company with a high dividend yield and low dividend payout ratio (or high dividend coverage ratio) indicates that the company’s dividend yield is supported by its strong earnings.

Consistently increasing dividends is one indication that dividends are supported by a company’s earnings and the firm is confident in its ability to generate profits. That rationale is also the investment thesis behind dividend growth strategies. Dividend growth rate, another important metric in dividend analysis, shows the percentage increase in dividends and can be presented as the product of return on equity (ROE) and earnings retention rate (which is 1 minus payout ratio). The formula shows that dividend growth is influenced by a company’s profitability and dividend payout ratio. A company with a high payout ratio (therefore a low retention rate) may still result in a high dividend growth rate if payouts are supported by high profits (ROE).

While the dividend growth rate helps capture the increases in dividend income, it is often considered an unpredictable factor.[1] [2] In addition, dividend yield, payout ratio, coverage ratio, and growth rate all evaluate dividends with respect to net income, which is an accrual accounting concept. Since the amount of dividends paid is shown on a company’s cash flow statement, another accepted measure is to use cash flow related fundamentals, such as free cash flow yield, to provide additional insight on company’s financial condition.

In our recently published research paper (Incorporating Free Cash Flow Yield in Dividend Analysis), we divided the S&P 500 member stocks into quintiles based on free cash flow yield. As of Dec. 31, 2017, the top-quintile stocks generated higher excess return than the remaining quintiles and outperformed the overall market by an average of 2.8% over the previous 27 years (see Exhibit 1).

In the paper, we incorporated free cash flow yield into a dividend strategy. Our analysis of a combined dividend and free cash flow yield portfolio[3] showed that a stable dividend income can be achievable when funded by sufficient free cash flow. As displayed in Exhibit 2, the portfolio’s 3.57% average dividend yield was supported by a 9.5% average free cash flow yield, compared with the benchmark’s 1.99% average dividend yield funded by 4.87% average free cash flow yield over the sampled history.

[1]   Cochrane, John H., The Dog That Did Not Bark: A Defense of Return Predictability. 2008.

[2]   Chen, Long, On the reversal of return and dividend growth predictability: A tale of two periods. 2009.

[3]   A hypothetical large-cap portfolio was formed with S&P 500 sector leaders in terms of integrated multi-factor value. The integrated value is the product of dividend yield score and free cash flow yield score, each of which is computed as transforming the standardized fundamental data to cumulative normal distribution, in the range of 0 to 1.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Where May Equities Go From Here?

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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February ended the longest historical monthly winning streak of 15 months for the S&P 500 (TR) that lost 3.7%.  On a total return basis for the month, 10 of 11 sectors lost, which has only happened in 12 of 342 months or 3.5% of the time (all 11 lost together in 13 months for a total of 25 or 7.3% of months where 10 or 11 lost together.)  Energy lost 10.8%, the most of any sector.  It was the 10th worst month on record for energy since Oct. 1989, and its worst month since Sep. 2011.  Rising inventories and concerns on Chinese demand put pressure on the sector, especially on the smaller companies that may be less hedged.  Only information technology was barely positive, up 0.1%.

Source: S&P Dow Jones Indices

The biggest story in February besides the correction itself may have been volatility  that almost tripled.  The annualized 30-day volatility rose from 8.1% on Jan. 31, 2018 to 22.5% on Feb. 28, 2018, and is the highest since Feb. 19, 2016.  To put it in perspective, the average going back to Feb. 12, 1988 is 15.2% and the volatility has only been greater than 22.5%, the current level, in 12.5% of times.

Source: S&P Dow Jones Indices.  The upper right chart is since Feb. 19, 2016, the last time volatility was as high as on Feb. 28, 2018.

While volatility has increased in many down markets, it may not be a bad thing and can provide some trading opportunities.  However, at this point, there may be some warning signs, particularly from the S&P 500 Bond Index, the corporate bonds of the companies in the S&P 500.  These bonds say a lot about the financial health of the companies in the S&P 500 since the performance (or conversely yields) of the bonds may be dependent on the credit rating and ability of these firms to make payments.  Given rising interest rates generally put pressure on the bonds, and the topic has been concerning for some time now, the S&P 500 Bond Index has already been negative in 4 of the last 6 months.  Perhaps even more importantly, the risk premium as measured by the monthly return of the S&P 500 TR minus the S&P 500 Bond Index was negative (in other words was a discount) back in August 2017 that showed pessimism in the market, despite a positive stock market return.  This is since when bonds outperform stocks it says investors may prefer to hide in the downside protection of the bonds rather than to participate in the upside of the stocks.  Additionally the record high optimism observed in Jan. 2018 could have been taken as a warning signal given the history of stock market performance after discounts follow high premiums.

Source: S&P Dow Jones Indices

And for a closer view of the past 3 years:

Source: S&P Dow Jones Indices

Does that mean one might want to completely sell stocks? Probably not, especially if one believes in long-term growth of the economy.  However, the risk premiums by sector can be one place to look for where to overweight or underweight in addition to other macroeconomic factors.  Right now every sector but information technology is measuring pessimistic, which is the broadest pessimism seen since Aug. 2015 when all sectors showed a discount.  Consumer staples, energy and real estate are showing notably big discounts that while bearish, are not necessarily bearish on the economy yet.  It is clear that the glass is half empty in energy from the inventory and Chinese demand concerns, real estate is one of the worst impacted sectors from rising rates, and consumer staples is basically a defensive play so when there is expected growth, the market may lean towards consumer discretionary.  Financials and information technology are the other two growth sectors to watch before worrying too much.

Source: S&P Dow Jones Indices

Lastly, looking at GDP growth, the dollar, interest rates and inflation, it seems that small-caps and mid-caps are better positioned than large caps now and that energy, materials, information technology and financials are better positioned than real estate, utilities and telecom.

 

 

 

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Considering REIT Lease Durations in a Rising Rate Environment

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John Welling

Director, Equity Indices

S&P Dow Jones Indices

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U.S. REITS have been lagging broad U.S. equities. During the recent climb in 10-year Treasury yields from the 2018 low of 2.41% on January 2, to as high as 2.94% on February 21, the Dow Jones U.S. Select REIT Index declined 11.2%. Though we have found that REITS have generally fared well over full cycles of rising rates, periods of sharper increases tend to weigh heavily on the minds of REIT investors.

However, REITs with shorter-term lease durations—apartments, hotels/resorts, manufactured homes, and self-storage—have generally fared more favorably. Theoretically, these REITs should be less sensitive to interest rates since they can reprice their rental agreements more quickly. The performance of the Dow Jones U.S. Select Short-Term REIT Index[1] illustrates this concept well, falling a lesser 9.3% over the same period, while its counterpart, the Dow Jones U.S. Select Long-Term REIT Index, fell 12.3% (see Exhibit 1).

If we expand the data to include the full run of the two most recent spikes in rates, we see that the Dow Jones U.S. Select Short-Term REIT Index has outperformed benchmark REIT indices. The performance of the Dow Jones U.S. Select REIT Index has been somewhat insulated by its exclusion of net-lease REITs, which tend to have relatively high sensitivity to interest rates. For this reason, we have also included the S&P U.S. REIT, which includes net-lease REITs as an added comparison (see Exhibit 2).

The Dow Jones U.S. Select Short-Term REIT Index has significantly outperformed the broader REIT market over the long run, with modestly lower volatility. This effect seems to be a byproduct of the index’s less-severe drawdowns during periods of rapidly rising rates.

It may be a good time for REIT investors to consider the duration of their REIT holdings. The Dow Jones U.S. Select Short-Term REIT Index may offer beneficial risk/return characteristics when compared to benchmark REIT indices, particularly during periods of rapidly rising rates.

[1]   https://spindices.com/documents/education/talking-points-dj-us-short-term-reits.pdf

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Laddered Protection

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Kevin Horan

Director, Fixed Income Indices

S&P Dow Jones Indices

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Continuing the theme of rising interest rates and following up from my last blog, “With all the News of Higher Interest Rates, Don’t Forget About Floating-Rate Debt,” bond laddering is a strategy that provides increased income and the ability to adjust the stream of income in a rising-interest-rate environment. The approach is to invest in specific maturity dates, or “rungs” of the ladder. For example, if you wanted to create a bond ladder today, you could buy bonds maturing in 2019, 2020, 2021, and so forth. The products used for such a strategy can vary, but are usually U.S. Treasury bonds, U.S. Municipal bonds, or corporate bonds.

S&P Dow Jones Indices has published many articles that address this topic. The educational paper, “Laddering a Portfolio of Municipal Bonds,” is a detailed piece that covers the construction and benefits of this kind of strategy.

To many people, the most important part of creating a bond ladder designed to preserve capital and build wealth in a rising-rate environment is buying individual bonds or defined-maturity ETFs.

However, it’s possible to keep a bond ladder intact by reinvesting that cash into a new longer-dated instrument. By rolling the proceeds into a longer-dated instrument, every time a shorter one matures, it’s possible to create a reliable income stream that may rise with interest rates over time.

Indices can be a helpful way to study the performance of a ladder strategy and the income producing result of the strategy in an increasing interest rate environment. In some cases, the index may have an investable ETF or ETP product issued against it, which gives an investors access to that segment of the market.

The indices in Exhibit 1 have been designed for use in laddering strategies.

Exhibit 1: Indices Designed for Laddering Strategies (Total Returns)

Source: S&P Dow Jones Indices LLC. Data as of Feb. 28, 2018. Chart is provided for illustrative purposes.

 For more information, please see these additional laddering articles:

Navigating Rising Rates: Municipal Bond Ladders by Matt Tucker

The Tactical Case for Bond Ladder ETFs by Matthew Forester

Fixed Income Laddering by Kevin Horan

Advisors Managing Interest Rate Risk With Municipal Bond Indices and ETFS by Shaun Wurzbach

Applying a Laddering Strategy to Preferred Portfolios in Canada by Phillip Brzenk

 

 

The posts on this blog are opinions, not advice. Please read our Disclaimers.