High yields often come with high volatility and capital decay. All high-dividend equity ETFs (VYM, SDY, SCHD, DVY, SPYD, etc.) have lagged the benchmark (SPY) in total return for years. In 2020, mortgage REITs and MLPs have been decimated. The iShares Mortgage Real Estate Capped ETF (REM) is still 46% below its 52-week high, and the ALPS Alerian MLP ETF (AMLP) is 52% below it. It means they need respective gains of 85% and 108% to fully recover, something which is not going to happen anytime soon. I really feel for investors who have bought MLPs and Mortgage REITs before the meltdown, attracted by a juicy yield. There is no magic formula to avoid all value traps and sucker yields. But there is one that cuts the probability of picking a rotten fruit.

What history tells you about yields

A recent article of mine shows that high dividend yields bring a significant and measurable risk of capital decay and volatility.

The sign your broker should show you before you buy high-yield stocks (Source: Pixabay)

However, stocks with a moderate dividend have had a better total return than the broad market over the long run. The next table shows the performance of a S&P 500 subset holding stocks paying dividends between 2% and 6%. The subset is reconstituted and rebalanced in equal weight every quarter since 1999.

Total Return

CAGR

DrawDown

Sharpe R

Volatility

S&P 500 2-6% yield subset

606.46%

9.40%

-56.65%

0.54

15.87%

S&P 500 Equal Weight (RSP)

491.68%

8.52%

-59.90%

0.45

17.41%

S&P 500 (SPY)

307.40%

6.67%

-55.42%

0.37

15.24%

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As stocks are in equal weight in the subset, the correct benchmark is the equal-weight index (RSP). Not only the subset has a higher return, but it has also a lower risk measured in maximum drawdown and volatility (standard deviation of monthly returns). Compared with the capital-weighted index (SPY), the risk is similar and the excess return is even better.

Filtering dividend companies with the Altman Z-score

The Altman Z-score is an indicator proposed in 1968 by Edward Altman, professor at New York University and expert in distressed debt. It is based on previous work by accounting researchers in the 1930s and aims at quantifying the risk of bankruptcy. According to initial studies, the Altman Z-score was supposed to be 72% accurate in predicting bankruptcy happening in the next 2 years, with 6% of false negatives (non-predicted bankruptcies). Later studies found it even better in accuracy, but with a higher rate of false negatives.

I use it in some of my models to avoid high-risk companies. It was designed for manufacturing companies, with later variants for non-manufacturing and private companies. However, the original version offers a significant statistical bias on the risk-adjusted performance in the broad market. For this purpose (which is not predicting bankruptcy), it seems to be effective even in recent times and in categories where it is supposed not to work (financials, for example).

The next table shows the simulated performance of the previous dividend stock subset after eliminating companies considered by the Altman Z-score to be in the distress zone (Z-score <1.81).

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Total Return

CAGR

DrawDown

Sharpe R

Volatility

2-6% yield subset w/Z-score

808.88%

10.68%

48.07%

0.61

16.18%

2-6% yield subset

606.46%

9.40%

-56.65%

0.54

15.87%

S&P 500 Equal Weight (RSP)

491.68%

8.52%

-59.90%

0.45

17.41%

S&P 500 (SPY)

307.40%

6.67%

-55.42%

0.37

15.24%

Data calculated with Portfolio123

Improvements in return and maximum drawdown are quite impressive compared with the unfiltered subset. The Altman Z-score provides a significant additional excess return and risk-adjusted performance (Sharpe ratio). It brings a statistical risk reduction on a number of trades, not a guarantee on individual stocks. Usual disclaimer: Past performance is not a guarantee of future returns.

Bottom line

  • Don’t chase high yields. A 2-6% range is a good place to start.
  • The Altman Z-score may help you avoid bad picks.
  • I use it in my QRV Stability portfolio, which represents a part of my real holdings. It is available to Quantitative Risk & Value subscribers.

 QRV Stability is a portfolio of dividend stocks designed to outperform its benchmark and equity dividend ETFs. Quantitative Risk & Value (QRV) provides you with a toolbox and educational content to implement data-driven strategies and monitor market risks. Get started with a two-week free trial and see how QRV can improve your investing decisions.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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Via SeekingAlpha.com