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Dividends as alternative sources of income

Today, there are more investment choices than ever before. Yet, when looking for income, a lot of investors tend face two options:

• Take More Risk: Usually, this ends up being “credit” risk, which deals with the chance of an entity being able to meet specific obligations. Common strategies may focus on “High Yield” or “Floating Rate” debt, or dealing with European Banks, AT1 Coco Bonds. Why is there more income? To compensate investors for taking greater risk that payments won’t be made.
• Accept Lower Income: People are aging, so “lower income” may not necessarily be an option for everyone. If safety of principal is the primary objective, then there is little safer than government debt of some of the world’s most creditworthy countries, such as the United States, Germany or Japan. We cite these three countries because they also have exhibited “safe haven” characteristics, meaning that when investors are nervous, the value of these assets has historically tended to rise.

The ugly nature of inflation

Inflation is important to consider because it may be one of the most significant challenges facing investors in the future. Central Banks printed an awful lot of money in response to the Global Financial Crisis of 2008-2009. History has indicated that typically the consequence of this response is higher inflation. Consider that, at 3% inflation, prices double every 24 years and at 5%, they double every 15 years. Inflation truly erodes real returns, as the purchasing power of future units of currency—be it British pounds, US Dollars or Euros—can buy less and less and less over time.

To give investors a sense of the current environment :

• The US 10-Year Treasury is yielding slightly more than 3.20%.
• The United Kingdom 10-Year Gilt is yielding almost 1.60%.
• The German 10-Year Bund is yielding less than 0.50%.
• The Italian 10-Year BTP (not currently in the headlines for its lack of risk—quite the opposite) is yielding nearly 3.40%.

An alternative may be dividend-paying stocks, as these are one investment option that could not only potentially provide income, but also have a higher potential for price appreciation—providing the opportunity to keep up with inflation. Consider that dividend equities:

• Offer the potential to grow your income stream through dividend growth, in fact, outpacing the rate of inflation over the entire history of the S&P 500 from 1957 to today .
• Provide potential growth of principal through price appreciation
• May offer more downside protection than their non-dividend paying counterparts

Dividends are everywhere

First, it is worth noting that dividends are quite prolific. Small, medium and large companies all over the world offer dividends, with nearly 35% from the United States, more than 18% from emerging markets and almost half coming from Europe and other developed international countries.

Figure 1: The world broken down by dividend stream weighted exposure

Sources: WisdomTree, Factset, Standard & Poor’s, with data measured as of the 30 September 2018 WisdomTree Global Dividend Index Screening. Historical performance is not an indication of future performance and any investments may go down in value. You cannot invest directly within an Index.

New paradigm for asset allocation?

While it is always difficult to make such a bold statement, we think that it is always important and valuable to look across different, logical alternatives. For decades, people have looked at equity markets and thought in terms of weighting stocks by their market capitalization (share price x number of shares outstanding). Doing this, roughly speaking, leads to approximately 50% weight to the US, 40% weight to the developed world ex-US, and 10% weight to emerging markets . Figure 1 substitutes “dividend per share” for “share price” in the aforementioned equation, and we saw the results in the regional allocations. Now might be an interesting time to be thinking in these ways, as the US equity market has tended toward strong outperformance for the better part of the past 10 years.

By Christopher Gannatti

This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.

Dividends could guide a global equity allocation

In a previous installment of our educational blog series on investment strategies and asset classes – The unique advantages of dividends – we discussed why and how WisdomTree weights by dividends.

It is worth noting that dividends not only provide the potential for downside protection, but also provide the potential for a growing stream of income.

Companies are paying larger dividends than ever

Today, more companies are paying dividends—and in larger amounts than ever before. In fact, many companies actually increase their dividends over time, providing a potentially growing stream of income that makes them an attractive investment option for investors of all ages.

For example, the Dividend Stream , the sum of all dividends being paid has been growing—with the total global dividend stream now at nearly $1.5 trillion!

Figure 1: WisdomTree’s global dividend stream

Sources: WisdomTree, Standard & Poor’s, Factset. Data represents the constituents of the WisdomTree Global Dividend Index, measured as of each annual rebalance screening. You cannot invest directly within an Index. Historical performance is not an indication of future performance and any investments may go down in value.

Global breakdown of dividends by region

Another interesting aspect of the global dividend landscape regards where the dividends, regionally, are coming from. Figure 2 allows us to draw a few key conclusions:

1. The world’s largest dividend-paying regions on a dividend stream basis are the United States and Europe.
2. The United States is interesting, in that it has the largest dividend stream out of the regions shown, but only 76.7% of the market capitalization of the MSCI USA IMI Index was in stocks that had paid at least one dividend over the past 12 months, as of 30 September 2018. The MSCI Europe IMI Index showed 97.0% of Index weight in stocks that had paid at least one dividend over the 12-months prior to 30 September 2018, a large difference.

Figure 2: Breakdown of the global dividend stream by region

Sources: WisdomTree, Factset, Standard & Poor’s. Data is measured as of the WisdomTree 30 September 2018 Global Dividend Index data screening. Asia Pacific refers to developed market countries in the Asia Pacific region, Japan, Hong Kong, Australia, Singapore and New Zealand. Emerging Asia Pacific refers to China, India, Indonesia, Malaysia, Philippines, South Korea, Taiwan and Thailand. For the % of Global Market Cap in Dividend Payers which comes from the MSCI ACWI IMI Index in this case, Pakistan is also included, but it is not an eligible country within WisdomTree’s Global Dividend Index. Canada, Emerging Europe, Emerging Latin America, Europe, Israel, the United States and Global refer to the MSCI Canada IMI, MSCI Emerging Europe, MSCI Emerging Latin America, MSCI Europe IMI, MSCI Israel IMI, MSCI United States IMI, and MSCI ACWI IMI Indices for the % of Global Market Cap in Dividend Payers.

This measure is calculated as the percent weight in firms that paid at least 1 dividend over the prior 12-months, as of 30th September 2018. You cannot invest directly within an Index. Historical performance is not an indication of future performance and any investments may go down in value.

Dividends as a guide to global equity allocations

Dividends are also becoming quite prolific. Small, medium and large companies all over the world offer dividends. We spend a lot of time helping investors think about a global equity allocation.

Market capitalization—the starting point

Investors today are extremely familiar with the allocations that come from market capitalization-weighting. US equities receive nearly 55% of the exposure, followed by developed world excluding US at 34.4% and emerging markets at nearly 11%, as illustrated on figure 3a. Now, many people also cite that the US equity market has been among the world’s strongest exposure for an extended period, looking back to the Global Financial Crisis of 2008-09.

Dividend stream weighting—a method sensitive to relative valuation

Instead of allowing the share price multiplied by the number of shares outstanding to dictate exposure, investors might consider allowing the dividend per share multiplied by the number of shares outstanding to drive the result. As we mentioned earlier, WisdomTree calls this term the dividend stream. This would shift weight from the US towards both the Developed World ex-US and to the Emerging Markets. Yes, such an approach would have underperformed over the past 10 years, but on a forward-looking basis, it creates an interesting, differentiated starting point.

Figure 3a: The world broken down by market capitalization weighted exposure

Source: Bloomberg, with data measured for the MSCI ACWI IMI Index as of 30 September 2018. You cannot invest directly within an Index. Historical performance is not an indication of future performance and any investments may go down in value.

Figure 3b: The world broken down by dividend stream weighted exposure

Sources: WisdomTree, Factset, Standard & Poor’s, with data measured as of the 30 September 2018 WisdomTree Global Dividend Index Screening. You cannot invest directly within an Index. Historical performance is not an indication of future performance and any investments may go down in value.

WisdomTree weights by dividends to potentially magnify the impact of dividends on performance. In addition, we conduct an annual rebalance back to relative value in order to manage valuation risk. This process is designed to help portfolios generate more income than their market cap-weighted counterparts.

Don’t Forget about the “Little Guys”

The equity market has been extremely focused on when the Federal Reserve (Fed) is going to raise interest rates, and expectations are consistently changing with the release of any relevant data point. Consensus is that the Fed will abandon its zero interest rate policy at some point over the next year, but the timing of this first interest rate hike has been highly debated. Even more uncertainty surrounds the rate hike trajectory and the longer-term target level of interest rates. What is not debated is the fact that many investors need their portfolios to generate income, and this percentage is expected to increase as the baby boomers transition into retirement. But with interest rates still near record lows across the globe, many investors continue to look beyond traditional asset classes for income generation. We think that they mistakenly overlook mid- and small-cap dividend payers. We believe mid- and small-cap dividend payers deserve a larger allocation in most investors’ long-term portfolios—particularly portfolios targeting income strategies—for both their current income and potential growth characteristics.

In Search of Income: Look to Mid- and Small Caps

We believe that many investors mistakenly assume that mid- and small-cap companies are solely focused on growth and therefore reinvest their earnings instead of paying them out in the form of dividends. When looking at traditional market cap-weighted indexes for the United States in particular, this assumption seems to be accurate. Going down the size spectrum, from the S&P 500 (large cap) to the S&P 400 (mid-cap) and the S&P 600 (small cap), in the Standard and Poor’s index family of market cap-weighted indexes illustrated in figure 1, the indexes that focus on larger market capitalization companies have higher trailing 12-month dividend yields.

However, this does not necessarily have to be the case; there are many profitable mid- and small-cap companies that can afford to, and do, pay dividends. Market capitalization-weighted indexes provide the benefit of as broad an exposure as possible to a given universe of stocks, but they do not directly focus on dividends or dividend payers.

When WisdomTree applies its domestic dividend methodology, it includes only dividend-paying companies and then weights these constituents based on their Dividend Streams®. These elements tend to produce very different trailing 12-month dividend yields for WisdomTree’s LargeCap, MidCap and SmallCap Dividend Indexes.

**Figure 1: Market Cap Weighting vs. Dividend Stream Weighting**

• In the current environment, WisdomTree’s domestic Dividend Indexes turn this way of thinking on its head—the WisdomTree SmallCap Dividend Index has a yield advantage over the WisdomTree MidCap Dividend Index, and the WisdomTree MidCap Dividend Index has a yield advantage over the WisdomTree LargeCap Dividend Index.

**Figure 2: Market Cap Weighting vs. Dividend Stream Weighting by Sector**

• Weighting eligible companies in our Indexes by dividends, rather than by market cap, enables us to magnify the effect dividends have on performance and potentially raise a portfolio’s trailing 12-month dividend yield. Unlike weighting by dividend yield, which can concentrate weights in the highest-yielding sectors, WisdomTree’s process of being broadly inclusive enables our core dividend Indexes to remain properly diversified across sectors while also increasing income.

Managing Valuation Risk

Another important thing to consider when investing in mid- and small-cap companies, which typically trade at higher multiples as a result of their higher growth potential, is managing valuation risk. With market capitalization-weighted indexes, when constituents increase in price compared to other stocks, they gain greater weight and increase their impact on the performance of the index.

WisdomTree Indexes employ a rules-based rebalancing mechanism that adjusts relative weights based on underlying dividend trends. During the rebalancing process, which occurs once per year for each Index, the relationship between price change and dividend growth is measured. WisdomTree’s Dividend Index rebalance process typically is driven by both:• Dividend growth: Faster dividend growers see weight increased• Relative performance:- Underperformers typically see weight increased- Outperformers often see weight decreased

Important Risks Related to this Article

Dividends are not guaranteed and a company’s future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.