Advisors face this problem every day: Fixed-income rates are low, but aging clients need to generate income. People are looking for yield, says Bob Zenouzi, lead manager of the Delaware Dividend Income Fund.
Despite the name of his fund, Zenouzi prefers to offer his investors total return these days. He believes that it is the best way to approach the mismatch between current yields and investors income needs.
Zenouzi contends that many traditional income bastions including utilities, master limited partnerships, mortgage REITs and health care REITs have become bond surrogates and are therefore too pricey in todays market. When you look at the highest quintile dividend yield, the P/Es of those companies are trading at a 20% premium to the S&P 500 P/E; and historically they traded at a 20% discount, he says.
We own some, but were just really underweight, he explains. So weve lowered the yield in our fund which, frankly, hasnt been too popular with many advisors and investors, but we think its the right thing to do.
Instead of focusing on the juiciest yields, Zenouzis team buys issues that it believes are likely to increase dividend payments. To me the risk isnt so much in buying good equities with competitive dividend yields that can grow; the risk is chasing the highest yields, Zenouzi says. He sees danger in overvalued, high-yielding equities as interest rates inevitably rise. When they get to these expensive levels, they become much more correlated to the 10-year Treasury, he explains.
The funds 30-day SEC yield was recently 1.92%, though the 12-month trailing yield was slightly higher at 2.25%. Competitors who stuck to higher-yielding stocks underperformed last year, Zenouzi says. His fund delivered a total return of 19.7% in 2013, vs. 16.48% for the moderate allocation category, according to Morningstar.
As is often the case, Morningstar compares Delaware Dividend Income in multiple categories. Against the Morningstar moderate target risk category, the fund does even better. Moderate target risk funds returned 14.31% last year on average, so Zenouzis portfolio outpaced them by more than five percentage points.
This year through March 31, DDIAX ranks 13th out of 920 funds in the moderate target risk category, according to Morningstar; over five years it ranks third among 666 funds in the category. Morningstar awards the load-waived version of the fund, available through advisors, an overall ranking of four stars out of five, observing that it delivers above-average returns but also carries above-average risk.
The research firm measures the funds beta at 0.65 vs. the Russell 1000 Value total return index, which Morningstar calls the best fit benchmark.
One reason for the lower volatility is that Delaware Dividend Income isnt limited to common stocks. Although the fund may have up to 45% of assets in junk bonds, the entire bond portion of the portfolio was recently a little more than 18% of the fund, and fixed-income investments are concentrated in high-yield debt and convertible securities.
Zenouzi notes that these securities provide a little extra safety because they sit higher in a corporations capital structure than common stocks. The fund may also buy investment-grade bonds, but it doesnt currently hold these issues because, Zenouzi says, they are more interest-rate sensitive.
REAL ESTATE HOLDINGS
Zenouzi, who helped create Delaware Dividend Income in 1996 and who has been lead manager since 2006, heads a team of 35 managers and analysts who work on the fund. He monitors the overall asset allocation and makes the final decision on it. Because he also serves as chief investment officer and lead manager for Delawares real estate securities and income solutions group, he is deeply involved in managing the realty sleeve of the portfolio, recently about 8.5% of holdings.
Currently, Zenouzi favors mall, apartment and shopping center REITs. But not all real estate can pass muster. One factor he considers is average lease length. We want shorter-duration leases within the REIT, he says, noting that a shorter lock-in of rents primes the properties better for economic growth. Recent REIT holdings included Simon Property Group, General Growth Properties and AvalonBay Communities.
The fund has underweighted financials, especially banks. Given Dodd-Frank and Basel III and capital ratio rules, they are less levered and theyll have less earnings growth going forward, Zenouzi says. We think that, over time, theyre going to act more like utilities.
Although DDIAX can invest up to 30% of its assets in stocks and bonds outside the United States, the vast majority of its holdings are U.S.-based. Emerging market issues are almost invisible in the current asset lineup. Zenouzi explains that, about four years ago, the funds managers concluded that slowing growth in China would cause emerging market investments to fall out of favor. I contend that the U.S. will continue to outperform the emerging markets for the next couple of years, he says.
For a fund that values dividend growth, Delaware Dividend Income appears to have fairly rapid portfolio turnover at roughly 50% annually. But initial appearances can be deceptive. Most of the turnover is in the high-yield bond sleeve, Zenouzi says. In large-cap value equities, which constitute about 45% of assets, the managers have very low turnover of about 8% annually.
They havent put a new name in the fund in probably a year and a half, Zenouzi explains.
In addition to real estate, the fund also favors energy, health care and communications services stocks. Among the funds recent top equity holdings are Halliburton (HAL), first bought in 2012, Merck (MRK), first purchased in 2009, and Verizon Communications (VZ), held since 2005.
The funds top 10 stock positions account for 14.5% of assets. The weighted average market cap of DDIAXs holdings is $66.6 billion.
In evaluating the large-cap value stocks that make up the largest portion of Delaware Dividend Incomes equity holdings, Zenouzis team considers price-to-earnings, price-to-sales, price-to-cash-flow and price-to-book ratios. Those metrics are compared with both the sector the company is in and the universe of stocks available. Valuation should always be the primary factor for investors, because thats how you protect your downside, Zenouzi says. Thats your margin of safety.
Current conditions are far from ideal for managing an income portfolio: The Fed is tapering asset purchases, yields remain low and unemployment is still stubbornly high.
It is challenging, admits Zenouzi, who contends that his teams policy of steering clear of equities with the richest yields will continue to be the best course for now. He believes that the Feds tapering will create some yield opportunities down the road, but for now investors seeking higher yields will face headwinds.
Zenouzi worries that some older baby boomers may still believe that they will be able to sell their stocks, buy bonds and just clip their coupons. You cant do that anymore, he says. You cant live on yield alone. You need to grow your capital or you will run out of money.
Joseph Lisanti, a Financial Planning contributing writer in New York, is a former editor-in-chief of Standard & Poors weekly investment advisory newsletter, The Outlook.
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