Investors seeking income-generating equity strategies should not have to choose between yield and quality, Research Affiliates has argued.
In a research article on income strategies, the company’s CIO Chris Brightman, head of equity research Vitali Kalesnik, and vice president of equity research Engin Rose cited Apple Co-Founder Steve Jobs’ principles when designing the iPhone.
“We believe the quality-yield trade-off is largely unnecessary.”“The iconoclastic iPhone design showed that the consumer can enjoy a product with rich functionality and ease of use,” the authors wrote. “We call this the AND principle… Instead of accepting unnecessary trade-offs, we seek to combine the qualities investors desire in a single vehicle.”
For equity income, Research Affiliates said investors usually had to choose between strategies that chased high dividend payers regardless of the quality of the underlying companies, or dividend growth strategies that focus on quality companies but with lower payouts.
“The consequence is that dividend-oriented strategies often must make a trade-off between quality and yield,” Brightman, Kalesnik, and Rose said. “We believe the quality-yield trade-off is largely unnecessary.”
The trio’s paper builds on previous research that showed how income portfolios could be improved by screening for financial distress, profit sustainability, and poor accounting processes.
After applying this filter to identify high quality, high-dividend payers, Brightman, Kalesnik, and Rose then applied a weighting strategy to optimise both yield and liquidity.
While traditional weighting methods—by market capitalization, yield, or equal weight—usually compromise liquidity or yield in some way, the authors argued that a “fundamental weighting” approach would minimize this effect.
“We believe investors can have both preferences [yield and capacity] by applying a fundamental weighting approach that intrinsically provides an excellent proxy of liquidity,” the authors said. Research Affiliates’ method “assigns larger weights to larger companies based on accounting measures”.
This approach involves weighting companies according to “fundamental measures of size” such as adjusted sales and retained cash flow.
As the late Apple CEO Jobs said—cited in Research Affiliates’paper: “Some people think design means how it looks. But of course, if you dig deeper, it’s really how it works.”
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