This is a guest contribution by Taylor Krystkowiak, Vice President of Product Management at Cboe Vest. Cboe Vest is the creator of Target Outcome Investments, which strive to buffer losses, amplify gains, or provide consistent income to a diverse spectrum of investors. The first of these leading-edge investments, Cboe Vest’s flagship Buffer Protect Strategy, was introduced in 2013.
Difficult Dynamics for Dividends
2020 proved to be a difficult year for dividends. Buckling under the unprecedented pressures of the pandemic, traditional dividend-oriented sectors struggled over the past year; Energy, Financials, Real Estate, and Utilities all logged negative annual returns. Energy suffered significantly as oil prices crashed, Real Estate revenues were strained by declining demand for office/retail space, and Financials/Utilities were sapped by historic unemployment spikes, business disruptions, and ongoing economic uncertainty. On the other hand, the valuation of the S&P 500 (see footnote 1) as a whole (as well as the vast majority of its individual sectors) rose significantly as price-to-earnings (P/E) (see footnote 2) multiples expanded to historic highs relative to long-term averages. Meanwhile, interest rates and bond yields fell to all-time lows in the wake of accommodative monetary policy, a major factor underpinning this expansion in equity valuations. The yield on the benchmark 10-year Treasury (1.08%) is near its all-time low, while the P/E ratio of the S&P 500 (30.70) is at an all-time high (see Figure 1).
These dual dynamics have driven dividend yields to historic lows and present a unique challenge to income-oriented investors. The current dividend yield on the S&P 500 is 1.58%, its lowest point in over 15 years.
Navigating the New Normal
In this new market environment, dividend-oriented investors are seemingly faced with a difficult decision: preserve yield at the expense of performance, or preserve performance at the expense of yield. Yet, a certain class of equities (aptly named the “Dividend Aristocrats”) has defied this prevailing dynamic.
In order to be considered a “Dividend Aristocrat,” a company must have increased its dividend every year for the last 25 consecutive years, a designation earned by only 65 companies in the S&P 500. Given that these companies have survived many other major storms that have swept the stock market over the past quarter century or more, it is unsurprising that this tried-and-true class of “aristocrats” proved to be uniquely resilient to the pressures posed by the pandemic. Simply put, they were the best suited to navigate this new normal, a reality reflected by both their performance and dividend growth. Over the course of 2020, the S&P 500 Dividend Aristocrats Index (see footnote 3) was one of the only major indices/sectors that both increased its yield and posted positive price performance (see Figure 2).
Driving Dividends with Derivatives
Yet, the current yield from the Dividend Aristocrats alone may be insufficient for some income-oriented investors. Traditionally, investors seeking the highest incomes have had to sacrifice quality or assume more risk in order to obtain higher yields. Currently, the only major indices/sectors that provide yields exceeding 4% are Energy, high-dividend equities, and high-yield bonds (i.e., sub-investment grade), all of which logged negative returns in 2020 and require investors to assume additional risk relative to higher quality assets (see Figures 2 and 4).
However, an alternative (and often under-utilized) option to increase income without necessarily sacrificing quality is leveraging the potential benefits of derivatives. Writing (i.e., selling) call options (see footnote 4) on a percentage of portfolio assets can be an effective way to boost income without compromising asset quality. Cboe Vest has utilized this strategy in its S&P 500 Dividend Aristocrats Target Income ETF (KNG), one of the few exchange-traded funds (ETFs) that allow investors access to the Dividend Aristocrats Index. The strategy seeks to obtain a total income target that is 3% above the annual dividend yield of the S&P 500 Index. The fund achieves this goal by not only holding stocks from the Dividend Aristocrats Index and collecting their dividends, but also writing call options on a percentage of the portfolio (see Figure 3).
Figure 3. Dividend Aristocrats Target Income Strategy
The net effect is a higher annualized yield than can be obtained purely through the Dividend Aristocrats Index; the current annualized yield of KNG is 4.29%, which is 1.66% higher than the current 2.63% yield of the Dividend Aristocrats Index (see Figure 4). As a result, KNG offers investors a yield that rivals even the highest yields provided by Energy (5.84%), high-dividend equities (4.90%), and high-yield bonds (4.89%), while maintaining exposure to the higher-quality and positively-performing stocks that comprise the Dividend Aristocrats Index. In short, the strategy offers an often elusive synergy between yield, quality, and performance, which may prove to be a competitive solution for income-oriented investors.
Note: Performance data quoted represents past performance. The ETF’s past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than their original cost. Current performance of the ETF may be lower or higher than the performance data quoted. You may obtain performance data current to the most recent month end by calling 855-505-VEST (8378).
A Strategic Solution for the Income Investor
As shown by its performance and yield, the Cboe Vest S&P 500 Dividend Aristocrats Target Income ETF has not only persevered but prevailed over the pressures posed by the pandemic. The fund continues to offer investors the opportunity to gain exposure to both high-quality equity growth as well as a highly competitive yield, and the diversified nature of its underlying Dividend Aristocrats Index mitigates single-stock and/or sector risk.
In short, the strategy has proven to be a sound solution that has succeeded in both stormy and steady conditions alike, which may make it a worthwhile addition to the portfolio of any income-oriented investor.
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