It’s not easy being an income investor. With pandemic-related interest rate cuts pushing bond yields to historic lows – the benchmark yield on the 10-year Government of Canada bond was 0.55 percent at the time of writing – and with a number of global bonds having negative rates, it's becoming increasingly more difficult to generate yield from fixed income securities.
“Negative yielding bonds now account for approximately 20 percent of total bonds outstanding,” says Benjamin Gossack, vice-president and director at TD Asset Management (TDAM). “Investors are guaranteed to lose capital if the bonds are held to maturity.”
Instead, investors are flocking to dividend-paying equities. In the first half of 2020, dividend-focused ETFs reportedly experienced net inflows of $580 million, while billions more have gone into income ETFs in the U.S.
While dividend-paying equities can boost an investor’s returns, many of these stocks are Steady Eddie blue-chip operations that only grow modestly in value from year to year. That may be suitable for retirees who want to create what’s essentially an annuity from their stocks, but most others are looking for better total returns – a combination of dividends and capital gains.
Since most growth stocks don’t have payouts, investors need to look farther afield to find something that offers attractive returns. One area to consider is the dividend-focused ETF space, which includes a growing number of actively managed ETFs where fund managers scour the investment universe for high-quality, and higher-growth, dividend-paying companies.
“You can find stocks that are cash generative businesses to support ongoing and progressive dividend payments, and also have strong competitive advantages to sustain and grow their cashflows, and earnings, over time,” says Gossack.
A different kind of income ETF
While there are a number of dividend ETFs to choose from, Gossack saw a gap in the ETF marketplace. There wasn’t much that focused on enhancing total returns, and many products were passive investments that tracked basic dividend-paying indexes, he explains. That’s why he and his team launched two income-focused actively managed ETFs, the TD Active Global Enhanced Dividend ETF (TGED), which hit the market in May 2019, and the TD Active U.S. Enhanced Dividend ETF (TUED), which was issued this past June.
Unlike many of their peers, these ETFs employ different strategies, including selling put options, call options and holding higher growth non-dividend payers, to generate income and additional returns.
“We wanted to build an ETF that was different from what else was on the market,” says Gossack, who manages the two funds. “It was important for us to take a flexible approach that doesn’t force us to apply a strategy that’s not suitable for a specific market environment.”
Both TGED and TUED hold market-leading companies, such as Microsoft, Apple and Alphabet, though the former owns more non-U.S. international stocks, like pharmaceutical giants AstraZeneca and Novartis.
To find these businesses, Gossack and his team tap into TDAM’s industry-leading equity analysis operation, which has, for decades, scoured the market for solid stocks to add to the firm’s many mutual funds – and now ETFs.
“Every single company we invest in is a high-quality business with sustainable competitive advantages, a solid balance sheet and with long runways of cash flow growth,” he explains. “The quality of the underlying businesses is the foundation of future performance.”
The businesses in these funds give investors exposure to blue-chip companies that have a proven ability to compound free cash flows, but also to brand name technology firms – TUED has a 30 percent allocation tech, while TGED has 23 percent of its assets in the sector – which benefit from long-term growth trends, such as cloud computing and 5G networking, says Gossack.
Enhancing returns with options
TD’s ETFs are also allowed to hold up to 15 percent of their assets in non-dividend companies, which tend to be higher growth than the income-paying ones. But actively using options can turn these high growth stocks to synthetic income producing ones, which really makes this fund different than the rest.
For the uninitiated, options are conditional contracts between two parties to either buy or sell a security at a predetermined price. There are two types of options contracts: put options and call options. While both transactions involve projection on the direction of stocks or stock indexes, a put option allows the buyers to sell the underlying asset in the future at the pre-set price, while a call option gives the buyer the right to purchase the underlying asset in the future at an agreed price. Thus, call options are a leveraged bet on the appreciation of a stock or index, while put options profit from price declines.
Most income products either apply put options or call options, but TDAM’s two ETFs use both.
“The selling of put options generate attractive yields from our cash and set us up to buy stocks we like at lower prices,” Gossack says. “We also write calls on stocks we own. It’s a painstaking process that includes selecting stocks to write calls on and determining how far above the current price the contract is set.”
Naturally, this process is complicated and involves a lot of work, but Gossack says it’s a great way to generate income for investors while realizing long-term capital growth. He and his team believe that their active approach, both on security selection and on the options overlay, sets them apart from their competition. This also allows them to focus on generating income, without sacrificing total return in the long run.
With most experts now predicting a lower yield, lower growth, and higher volatility environment, people will need to search for income in the equity market for the foreseeable future. It’s important for investors to do their research and ensure that what they’re buying gives them the income, and the growth, they need for their future.
“It’s never been a better time to focus on dividend investing,” notes Gossack. “With our ETFs, the higher the volatility, the higher the option premiums, and by extension, the more opportunities for investors. With still much uncertainty down the road, TDAM's actively managed option strategy could be a solution for many investors."