Performance of Australian high yield portfolios

Dividend yield premium: Risk or mispricing?

According to Standard and Poor’s, $3.6 billion is invested in Australian-listed exchange-traded funds with a yield strategy, a figure which has grown at an annual rate of 21 per cent over ten years.[i] Across countries there is a long history of high yield investments generating an annual return premium of about 1–3 per cent.[ii] 

But there is disagreement amongst researchers about the underlying cause. Are high yield stocks just riskier than other stocks? Or are investors’ decisions affected by a growth bias and career concerns (benchmark hugging) leaving returns on the table? High cash payouts act as a constraint on the tendency of executives to spend cash on acquisitions and other investments that increase company size but do not necessarily add value for shareholders.[iii] Perhaps investors persistently understate the discipline benefits of high payouts.

In Australia, dividend yields are double that of U.S.-listed companies, due to the imputation system encouraging high dividend payouts. What return can investors expect from high yield ETFs relative to the broader market, once inflation and taxes are taken into account? Further, do fluctuations in economic conditions affect the performance of high yield strategies? 

As discussed below, high yield investing has generated an annual return premium of 2.3 per cent. Well-diversified portfolios are no riskier than broader market portfolios, but there are two offsetting risk impacts: Below-average market exposure is offset by above-average interest rate risk. 

In addition, investors should note that while any particular investment style may outperform the broader market on average, performance will vary over time. This remains true of high yield investing. 

Finally, in implementing a high yield investment strategy, investors should ensure they are diversified across industries. Ranking purely on yield will lead to a portfolio concentrated in a small number of industries and amongst stocks at the peak of an earnings cycle.

Performance of high yield Australian-listed stocks

We investigated the performance of portfolios that target yield with reference to Australian-listed companies over 41 years from July 1982 to May 2023. We averaged monthly returns from the four yield series listed below, to smooth out the idiosyncratic contribution of each particular series portfolio formation rules. Returns include the benefits of imputation credits, are adjusted for inflation and are before investor personal taxes. 

We compared returns to those of the broader market. From May 1992 the market index is the S&P/ASX 300 Index and in earlier months the market index is the MSCI Australia Index.[iv]

Table 1. High yield return indices

Over 41 years, holding a portfolio of high yield stocks generated an annual return of 11.9 per cent (Figure 1). This represents a 2.3 per cent premium over the 9.6 per cent return on the broader market. Imputation credits matter. The tax benefits of imputation contributed 1.2 per cent to the 2.3 per cent outperformance, with the remaining 1.0 per cent attributed to a pure yield premium.

Figure 1. Real pre-tax investment value including imputation benefits

However, the risk profile of high yield investing is different to that of the broader market, despite aggregate portfolio volatility being about the same. Consistent with U.S. evidence, returns are sensitive to interest rate movements. 

We considered four drivers of returns: aggregate market returns, changes in 10 year bond yields, the level of 10 year bond yields, and real percentage changes in the RBA commodity price index (given that a high yield portfolio will necessarily have exposure to large mature mining companies).

Returns to the high yield portfolio are defensive. Specifically, if the broader market fell 10 per cent investors should expect a high yield portfolio to lose just 8.5 per cent. However, high yield investments are sensitive to interest rate movements. A 1 per cent increase in the 10 year bond yield is associated with a minus 0.6 per cent return to a high yield portfolio. Morningstar reported consistent evidence for U.S.-listed stocks: high yield portfolios outperform during periods of falling interest rates and underperform during periods of rising interest rates.[vi] 

However, after controlling for market risk and interest rate risk, the monthly outperformance (the “alpha” investors are searching for) is 0.31 per cent, which represents annual outperformance of approximately 3.7 per cent.[vii]

Does this mean investors should attempt to time their entry and exit to high yield portfolios on the basis of interest rate projections? Sure, if investors have the skill set to forecast interest rate movements, one of the most challenging portfolio formation tasks. And for the investor with the ability to forecast interest rates, the investor should be focused on the fixed income part of their portfolio. 

What the results for high yield investing imply is that high yield investments act somewhat like bonds. An investor with a high yield equity allocation should be aware there is interest rate risk in the investor’s overall portfolio and take this into account when considering diversification across other asset classes.

Investors should also be aware that the relative performance of high yield investing varies over time. We split the 41 years of returns into six economic regimes of approximately three to eleven years based upon changes in economic regimes, tax law and the onset of the pandemic (Figure 2). In five of the six regimes, the high yield portfolio earned annual above-market returns of at least 1.5 per cent. But over almost seven years ending January 2020, the high yield portfolio underperformed the broader market by 2.3 per cent.

The time periods could have been sliced in many ways which would have altered the returns series. But the key point would be unchanged. Investing on the basis of any one particular investment style will have sustained periods of underperformance, a problem which is acute when historical data plays an outsized role in the portfolio formation process. 

Many high yield investing strategies give undue weight to the prior year’s dividend. Dividend yields are mean-reverting: high trailing dividends will, on average, trend towards medium dividend yields. So the more consideration given to analyst dividend forecasts over trailing dividends, and the more timely those forecasts, the better.

Figure 2. Real after-tax returns to high yield investing in different economic regimes

Return months: Pre inflation targeting July 1982 to March 1993; RBA targets inflation April 1993 to June 2000; Imputation cash rebate introduced July 2000 to July 2006; US housing crash August 2006 to June 2013; Mid point of regimes 5 and 6 July 2013 to January 2020; COVID February 2020 to May 2023.

Income, growth and industry concentration across high versus low yield stocks

With evidence of a long-term yield premium, we considered the characteristics of income, growth and industry concentration across high versus low yield stocks. We analysed 403 stocks in the All Ordinaries Index for which 24-month forward analyst dividend and earnings forecasts were available on 30 June 2023, and show the characteristics of the high and low yield portfolios, based upon the top and bottom 25 per cent by market capitalisation (Table 2).

Table 2. Portfolio characteristics

If we rank stocks by dividend yield plus imputation credits and select the top 25 per cent of stocks by market capitalisation, the portfolio has the following characteristics.

• High 12-month forward dividend yield including imputation credits of 9.4 per cent;
• Low 12-month price-earnings ratio of 10; but
• 9 per cent decline in earnings per share over 12-24 months; and
• 96 per cent exposure to Basic Materials, Financials and Energy[viii] with the largest company exposures being BHP (ASX: BHP), National Australia Bank (ASX: NAB), Westpac (ASX: WBC), Fortescue (ASX: FMG) and Woodside (ASX: WDS).
• In addition, the portfolio would have no exposure to Health Care, Consumer Staples, Technology, Telecommunications and Utilities, which collectively comprise 23 per cent of the market.

Investors would be exposed to a high degree of concentrated risk in stocks at the peak of their earnings cycle in a small number of industries. A less risky approach would be to select the top 25 per cent of stocks by market capitalisation from within each industry. A portfolio formed from this sector-neutral approach would have the following characteristics.

• 12-month forward dividend yield including imputation credits of 7.9 per cent (down from 9.4 per cent)
• 12-month price/earnings ratio of 12 (up from 10); but
• Only a 2 per cent prospective decline in earnings per share over 12-24 months (up from minus 9 per cent); and
• Just 54 per cent exposure to the top three industries (down from 96 per cent) – Financials, Basic Materials and Industrials – with the largest company exposures being Westpac (ASX: WBC), ANZ (ASX: ANZ), Fortescue (ASX: FMG), Telstra (ASX: TLS) and Coles (ASX: COL).

The implication for investors is that they should be wary of forming a portfolio which is exclusively drawn from the highest yield stocks, without consideration of industry diversification. The evidence suggests there is a persistent yield premium – yield beats growth most of the time – but holding exclusively the high yield portfolio will expose the investor to industry shocks and interest rate rises. Investors can mitigate their risk exposure by holding the highest yield stocks from within each industry.

Conclusion

High yield investments are associated with above-market returns in Australia, with imputation benefits and a pure yield premium contributing approximately equal amounts to a 2.3 per cent annual premium. High yield investments have below-average market risk exposure, which is offset by above-average exposure to interest rate risk. A 1 per cent increase in the 10-year bond yield is associated with a minus 0.6 per cent return to the high yield portfolio. 

High yield investments are not guaranteed to earn a premium, even over extended time periods. This is generally true of any style-based portfolio formation process. But the typical yield premium is positive and a high yield portfolio carries no incremental volatility relative to the market. To mitigate risk, investors should consider industry diversification, rather than forming a portfolio purely on the basis of prospective dividend yield. High yield companies are mature, so in general have little earnings growth, and are concentrated in Basic Materials, Financials and Energy.