March 25, 2014
This paper analyzes the historic performance of the McKinley Capital Management, LLC (“McKinley Capital”) U.S. Equity Income strategy as interest rates changed. Despite what might be assumed, the products comprising the strategy tend to perform best in rising interest rate environments.
McKinley Capital has managed a U.S. Equity Income separate account strategy since 1991. Currently McKinley Capital offers both a wrap and non-wrap version of the strategy. The firm has managed wrap accounts in the strategy longer than non-wrap accounts; therefore, the U.S. Equity Income Wrap Composite (the “Composite”) data was used throughout this paper.
The McKinley Capital U.S. Equity Income strategy is designed primarily for investors seeking high levels of current income with moderate capital appreciation. While the portfolio largely consists of U.S. listed securities, it may hold dividend paying U.S. stocks, American Depository Receipts and other foreign stocks, Real Estate Investment Trusts, Master Limited Partnerships, Business Development Companies, closed-end funds and other stocks. Table 1 shows the percentage of holdings by type as of December 31, 2013 for the Composite. The realized distribution rate for the Composite over the past 10 years, ending December 31, 2013, has averaged +7.56%1. Investors also use the strategy, regardless of whether they seek high levels of income, because they believe high dividend paying stocks will outperform passive market aggregates over long periods of time.
In selecting investments for the U.S. Equity Income portfolio, McKinley Capital seeks stocks of companies that have above average distributions and growing payouts (payout momentum). McKinley Capital uses both a quantitative screening process and qualitative overlay to construct and manage investment portfolios. The investment process systematically searches for and identifies securities which have above average dividend yield, accelerating dividend payout amounts, favorable risk adjusted relative returns and adequate liquidity. For stocks under consideration, McKinley Capital seeks out the best analyst to determine his or her views on future dividends relative to consensus. Selected stocks are diversified across industries, sectors and market capitalization within the universe of securities with strong dividend characteristics.
For 2013, the Composite showed a gross return of +24.40% as compared to -2.02% for the Barclay’s U.S. Aggregate Bond Index (a pure fixed income index) and +32.39% for the S&P 500. The actual realized Composite distribution yield was +7.42%. Over the past ten years ending December 31, 2013, the composite showed an annualized gross return of +10.60% as compared to +4.55% for the Barclay’s Aggregate Bond Index and +7.41% for the S&P 500 (see Table 2)
As illustrated in Table 2 above, the returns of the Composite can differ significantly from the performance of both the S&P 500 and the overall U.S. bond market. There are a couple of reasons for the dispersion. First, McKinley Capital’s products are actively managed. McKinley Capital’s specific stock picks can add or subtract value compared to alternative investments. Second, like many income oriented equity investments, McKinley Capital’s U.S. Equity Income products typically have a lower standard deviation of returns than a general market basket like the S&P 500. In a year of strong and positive equity market returns like 2013, an equity income strategy may be expected to have a lower return than the S&P 500. In a down market year, the strategy may be expected to outperform the S&P 500. Since inception in 1991 and compared to the S&P 500, the up capture of the Composite is 69.35% with a down capture of 31.69%. Stocks with significant dividend payments, like the stocks targeted by McKinley Capital’s U.S. Equity Income strategy, are often more defensive in nature than other stocks. Since the strategy’s inception in 1991, the Composite has outperformed the S&P 500 in each of the 4 years where the S&P 500 had a negative return. Over the same time span, the S&P 500 had 19 years of positive returns. In 9 of those 19 years, the Composite outperformed the S&P 500. Overall, the Composite has outperformed the S&P 500 since its inception.
Recently, analysts have suggested the possibility of a continued increase in the level of U.S. interest rates as the economy continues to recover and the U.S. Federal Reserve continues to slow down its purchase of U.S. Treasury securities. What might happen to the returns of McKinley Capital’s U.S. Equity Income products should interest rates continue to rise? Typically, pure fixed income investments underperform when interest rates increase as demonstrated by the negative return of the Barclay’s Aggregate Bond Index in 2013 when the 10-Year Treasury yield increased from 1.76% to 3.03%. Since the firm’s U.S. Equity Income portfolios are income oriented, investors might suppose the portfolios would react negatively when interest rates increase. However, unlike bond investments, the dividends paid by the companies in the McKinley Capital’s U.S. Equity Income portfolios are not fixed. Historically, McKinley Capital has held companies with increasing dividends and to the extent that dividend increases offset higher interest rates, the impact of increasing interest rates on McKinley Capital’s portfolios could be moderate.
Since 1995, returns of the Composite have been higher during quarters with increasing interest rates than during quarters of declining interest rates. Significantly, the Composite has performed better than traditional fixed income bond investments, as measured by the Barclay’s Aggregate Bond Index, when interest rates increase. Thus, it appears that McKinley Capital’s ability to find high and accelerating dividend paying stocks partially offsets the negative effect of higher interest rates on high current yield securities.
During the 18 years from the beginning of 1996 to the end of 2013, the average quarterly gross return of the Composite was +2.59% as compared to +2.40% for the S&P 500 and the +1.38% for Barclay’s U.S. Aggregate Bond Index (see Table 3).
During the 18 years covered by Table 3, there were 36 quarters when the 10-year U.S. Treasury yield increased and 36 quarters when the yield decreased. During quarters when the Treasury yield increased, the Composite had an average gross total return of +3.37%. During quarters when the Treasury yield declined, the same composite had an average gross total return of +1.80%. The 18-year correlation between the Composite returns and interest rate changes was 0.36. Last year was a good example of a rising interest rate environment. As noted above, during 2013, the 10-year Treasury yield increased from 1.76% to 3.03%. For the year, the Composite had a +24.40% gross total return, well above the 10-year annualized return of 10.60%.
Are the results shown in Chart 1 counterintuitive? Perhaps not. As already discussed, the prospect of increasing dividend payments on McKinley Capital holdings differentiates McKinley Capital’s U.S. Equity Income products from more traditional fixed income products. Rising dividend payouts may offset the effects of higher interest rates. Also, it is important to consider why interest rates go up. When the economy strengthens (allowing companies to pay higher dividends) the U.S. Federal Reserve often seeks to raise/normalize interest rates. Thus, rising interest rates are often associated with economic strength, higher dividends and strong equity markets. However, during periods of rising interest rates, pure fixed income investments can suffer. Therefore, McKinley Capital’s U.S. Equity Income strategy of seeking high and accelerating current income from the equity markets creates the potential for superior performance, particularly in current market environments.
To further analyze this paradigm, McKinley Capital computed the performance of the S&P 500 when interest rates changed. In the 36 rising interest rate quarters, the S&P 500’s quarterly average return was +5.24%, while in the 36 falling interest rate quarters, the quarterly average return was -0.44%. Given the discussion above, it makes sense that S&P 500 returns would be positively and strongly correlated with changes in interest rates. The computed correlation over the 18 year time frame was 0.57. In the context of strong S&P 500 returns in periods of rising interest rates, McKinley Capital would expect strong performance from the firm’s U.S. Equity Income strategy. This is exactly what occurred in 2013. Of course, unlike a S&P 500 investment, the goal of the U.S. Equity Income strategy is to provide above average income from dividends and other distributions.
Because of their static distribution characteristics, fixed income investments should act in the opposite direction. As expected, in the 36 rising interest rate quarters, the quarterly average return of the Barclay’s Aggregate Bond Index was -0.04%. In the 36 falling interest rate quarters, the quarterly average return was +2.80%. The correlation over the 18 year time frame was -0.89. While an active allocating investor that expects dramatically falling interest rates might react by increasing its portfolio bond weight, the investor could also invest in McKinley Capital’s U.S. Equity strategy given the strategy’s prospect of high current income and adequate historic returns. Over a wide range of economic environments, including eras of rising interest rates, McKinley Capital’s U.S. Equity Income strategy has the potential for excellent performance with high levels of current income. Even in declining interest rate environments, the strategy has performed at a satisfactory level.
Retirees and others with a need for current income often seek to analyze the impact withdrawals will have on account value over time. McKinley Capital believes that the purchase of stocks with high and growing dividends can help offset the effect of withdrawals and work towards maintaining the value of the account. Chart 2 simulates the impact of withdrawals on a fictional account in the Composite over the last 15 years through the end of 2013. The example assumed a $1 million investment with quarterly withdrawals. At the end of the first quarter, $12,500 (1.25% of the account value) was withdrawn. Each quarter the withdrawal amount increased by the rate of inflation. In the last quarter of 2013, $17,787.94 was withdrawn. Despite the increasing withdrawal amount over time, the final account value increased to $2.17 million from the initial level of $1 million. The simulated result was due to strong equity returns as well as the holding of stocks with high and increasing dividend payments.
Your McKinley Capital marketing representative would be pleased to discuss the ways that the firm’s U.S. Equity Income strategy can help meet the needs of your clients.
1 McKinley Capital does not employ leverage in managing the Separate Accounts. However, it is likely that some of the companies, whose stocks are held in the portfolios, do employ leverage in their businesses.