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How chasing yield affects expected returns

(MoneyWatch) The Federal Reserve's easy monetary policy has led many investors, especially those who take a cash flow (instead of a total return) approach to their portfolio, on a desperate search for yield. The search typically begins by moving some assets from high-quality bonds, such as Treasuries, government agencies, FDIC-insured CDs and investment grade bonds, to riskier bonds, such as high-yield and junk bonds. Another alternative that has become more "fashionable" is to move assets from safe bonds to assets with stock-like risks (assets whose prices tend to fall sharply when stock prices fall sharply). Probably the two most common alternatives are REITs and stocks with high-dividend yields.

With this fixation on yield, investors may have lost sight of the impact of valuations on expected returns. And the chase for yield has driven valuations on REITs and high-dividend paying stocks to levels that have a large impact on their expected returns. We'll begin by looking at the outlook for U.S. REITs.

A common way of forecasting returns is to take the current dividend yield and add to that the expected growth in earnings/dividends. That produces the expected real return. If you want the expected nominal return, you add the expected rate of inflation. This methodology assumes that valuations (P/E ratios) won't change. If you want to make an assumption about valuations changing (perhaps reverting to a long-term mean), you would have to adjust the forecast accordingly. With this in mind, what's the outlook for expected returns to REITs?

The Vanguard REIT Index Fund (VGSIX) has a current dividend yield of about 3 percent. Now we have to add the forecast for expected real growth in that dividend. What's likely a surprise to most investors is that the data from NAREIT shows that while inflation has averaged 4.2 percent over the past 41 years, REIT dividends have only grown about 2.6 percent, producing a negative real growth of 1.6 percent. (Contrast this with the real growth for stocks of about 1.5 percent.) The result is that we have a forecast for real returns to REITs of just 1.4 percent. If we add in expected inflation of 2.3 percent (from the Philadelphia Federal Reserve's Survey of Professional Economists), we get a nominal expected return of just 3.7 percent. Now contrast that with the historical return REITs have provided investors.

From 1978-2012, the Dow Jones U.S. Select REIT Index returned 12.6 percent. During this period, inflation was 3.8 percent. Thus, REITs provided a real return of 8.8 percent. Investors who wrongly rely on historical returns to project future returns are likely to be sorely disappointed. In addition, investors are taking all the risks of REITs -- which have risks very similar to the risks of stocks in general with an annual standard deviation for the period of 18.8 percent versus 15.4 percent for the S&P 500 -- for an expected real return of just 1.4 percent. And that doesn't assume any reversion to the mean of REIT valuations.

We can also compare the expected real return to REITs with the expected return of U.S. stocks in general. We'll use two approaches to forecast stock returns. The first uses the same dividend model we used for REITs. The Vanguard Total Stock Market Fund (VTSMX) has a current yield of about 1.9 percent (the same as that of the S&P 500). Add to that the historical growth in earnings of 1.5 percent, and we get an expected real return of 3.4 percent and a nominal expected return of 5.7 percent, a full 2 percent greater than the expected return to REITs. As you see, yield and return are very different.

The other approach is to the Shiller PE 10, which is currently at 24.6. That produces an earnings yield of 4.1 percent. Because the PE 10 reflects the average earnings over the past 10 years, we have to adjust it upwards to account for the 1.5 percent annual growth in earnings. To do that, we multiply the 4.1 percent by 1.075 (1.5 x 5 years, the average time lag), and we get an expected real return of 4.4 percent, and a nominal expected return of 6.7 percent, or a full 3 percent above the expected return on REITs.

One last point on the risks of investing in REITs: They have significant exposure to term risk. A factor analysis shows that from 1978 through March 2013, they have a 0.15 loading on term premium. Since we've basically been in a bull market in bonds over the period, REIT returns have benefited from the fall in rates. Should rates rise, REIT returns will likely be negatively impacted.

We'll now turn our attention to high-dividend-paying stocks. As we have pointed out many times, a high-dividend strategy is a value strategy -- anything with a low price to some metric like dividends, earnings, sales, cash flow, or book value is a value strategy. We also know that higher valuations predict lower future returns. When we look at the various valuation metrics for the SPDR S&P Dividend ETF (SDY) and compare them to those of the Vanguard Value Index Fund (VIVAX), we find that:

  • VIVAX has a price-to-earnings ratio of 11.8, while SDY is at 16.5
  • VIVAX's book-to-market ratio is 1.5, while SDY is at 2.6
  • The price-to-cash-flow ratio is 5.6 for VIVAX and 9.0 for SDY

All three metrics show that the higher-yielding SDY now has significantly lower expected returns than does VIVAX, despite the similar value oriented strategy.

The bottom line is that investors lusting after yield have not only increased the risks of their portfolios, but also seem to have made poor choices. A more effective way of achieving higher expected returns would be to invest in value stocks, with value being defined not by a high dividend yield but rather by low price-to-book market value, low price-to-earnings or low price-to-cash flow.

Another alternative is for investors to increase their allocation to international stocks, which currently have higher expected returns than domestic stocks. We can see that by comparing the valuation metrics of VTSMX and Vanguard's Total International Fund (VGTSX). VGTSX has a dividend yield that of 3 percent, 1.1 percent higher than that of VTSMX, and its P/E ratio is 12.9 compared with 14.7 for VTSMX.

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