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Equity Perspectives

Through a balanced design and a focus on valuation, Lord Abbett has steered the Affiliated Fund to remarkably consistent returns.

 

In Brief

  • With our Affiliated equity income strategy, we emphasize a balanced approach to constructing a strategic allocation. The portfolio draws from all the sectors where dividends can be found, not just typical “bond proxy” groups.
  • Dividend payers have become increasingly diverse in both style and sector in recent years.
  • Equity income managers have good reason to draw from various styles and sectors for dividends: recent research showed that dividend-paying equities outperformed non-dividend payers in risk-adjusted terms across styles and market capitalization (for the period July 1963–December 2014).
  • Well-diversified portfolio construction also has the potential to mitigate the “lumpiness” in active return that sometimes can be associated with equity income.
  • The key takeaway: Our broad-based, diversified approach to equity income resulted in strong performance for Affiliated during three shifts in U.S. interest rates from January 2016–June 2017—and since the inception of the Calibrated approach in June 2013.

 

In this article, we will explain the origins of the broad-based, diversified approach used by Lord Abbett to manage its Affiliated equity income portfolio. We also will detail the process by which we arrive at our strategic allocation, and review recent dynamics in equity income investing that highlight the potential advantage offered by the Affiliated strategy.

For more than four years now, Affiliated has been managed by the Calibrated process, which is distinguished by factor neutrality relative to an initial strategic allocation. Such an allocation can be thought of as a “smart beta” index or a designed allocation. This designed allocation includes tilts, weightings, and/or various caps to emphasize certain characteristics. That is, it is not just a screen of stocks that results in a universe but also it is weighted and tilted to achieve some investment outcome or some set of attributes that investors may wish to utilize.  

A strategic allocation includes tilts, weightings, and/or caps to emphasize certain characteristics in an index. It is not just a screen of stocks; it is carefully designed to achieve a desired investment outcome.

Creating the Universe
In our style box-oriented Calibrated funds, the starting allocation is straightforward, drawing on the definitions established in the widely recognized Morningstar style box.1 We then construct portfolios of undervalued stocks, while maintaining factor neutrality relative to that initial allocation. By minimizing the impact of factor movements on active returns, this approach emphasizes stock selection as a driver of active portfolio returns. With Affiliated, we wanted the starting point to be a value-oriented equity income style. More important, there is no straightforward starting allocation for this style. We needed to create that neutral allocation. So, we defined, through a set of rules and scaling factors, “what it means to be equity income.” (This definition and the subsequent strategic allocation construction process is always subject to review and change, depending on market conditions and investment objectives.)

How does that work in our current practice? We start with the 1,000 largest U.S. companies (as represented by the Russell 1000® Index). Of those, we seek stocks that pay a substantial dividend. So we screen to the top 70% of dividend payers in the Russell 1000 Index. As of March 31, 2017, there were about 730 dividend payers in the index, so culling the top 70% of that group yields roughly 500 stocks.

 

Chart 1. Where Do We Start?

Source: Lord Abbett.
The Fund’s portfolio is actively managed and portfolio characteristics, such as individual holdings and sectors may change over time. Diversification does not guarantee a profit or protect against loss in declining markets. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is no guarantee of future results. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

 

Those 500 or so stocks represent Affiliated’s investment universe. It’s broad in scope, containing mid- and large-cap stocks, and is diversified among sectors and industries. Already, through this unbiased view, we are starting to differentiate from competitors that rely on just a few traditionally dividend-focused sectors.

But we want to create an investable allocation as a starting point, not just a universe of stocks. The factor tilts of this allocation are important, because our final portfolio will be factor neutral relative to this starting point. So the starting point itself needs to display the major factor characteristics that we want the final portfolio to feature: in Affiliated’s case, they are value and income production.

Creating the Allocation
To create a starting point with the requisite characteristics, we take the 500 dividend-paying stocks and rank them according to their Russell value score, which is derived by blending price-to-book value and forward sales and earnings growth measures. We then assign a scaling factor to this list, increasing the weight of the stocks with the highest value score and decreasing the weight of those with the lowest score. This step ensures the starting allocation and the final portfolio will map to the Morningstar Large Value style box without disregarding the role that growth stocks can play in universe expansion and portfolio diversification. We also cap the weightings of the allocation to real estate investment trust and utility stocks at their weightings in the Russell 1000® Value Index. This ensures diversification among industries. (As a reminder, no investment strategy, including diversification and asset allocation, guarantees a profit or protects against a loss.)

Further, we cap the weight of any individual stock for diversification reasons as well. Because this is a starting allocation, the active weight of an individual security is added (or subtracted, in the case of an underweight) to this allocation weight in the final portfolio.2

 

Chart 2. What Are the Next Steps?

Source: Lord Abbett.
Past performance is no guarantee of future results. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

With these steps, we create a starting allocation that represents value-oriented equity income. That starting point can be thought of as a smart beta design, because we are using factor tilts, screens, and caps to determine index weights that are distinct from simple market-cap weights and screens.

Style Diversity
The value scaling factor ensures that the portfolio will plot to large-cap value, but the income-based universe definition will mean that the allocation and the final portfolio typically will have higher yield than the Russell 1000 Value Index. Though tilted to value, the allocation includes a substantial number of growth and core stocks. (Note that value and growth stocks may respond differently to changes in economic conditions.)

This is an important feature of Affiliated’s strategic design. In a recent article in the Financial Analysts Journal, “What Difference Do Dividends Make?” authors C. Mitchell Conover, Gerald R. Jensen, and Marc W. Simpson showed that, historically, stocks that provided a dividend yield were found to have higher total returns and lower volatility than those that did not pay a dividend. The study (summarized in Table 1) looked at dividend payers within all the major style boxes over five decades, showing that the return and volatility advantages of dividend payers were distinct from the outperformance provided by the value style, meaning it makes investment sense to consider dividend payers outside their traditional place in large-cap value.

 

Table 1. Dividend Payers Can Be Attractive in Many Styles
Return and risk (standard deviation) by equity fund style, July 1963–December 2014

Source: C. Mitchell Conover, Gerald R. Jensen, and Marc W. Simpson, “What Difference Do Dividends Make?” Financial Analysts Journal (November/December 2016). The study covers the period from July 1963 through December 2014; overall, the sample period includes 51.5 return measurement years of data (618 months of returns). This table reports the value-weighted geometric mean monthly returns and standard deviations of portfolios formed on the basis of market cap (or market equity), book-to-market ratio (book equity/market equity), and dividend yield (trailing 12 months). The mean return refers to the expected value, or mean, of all the likely returns of investments comprising a portfolio. Standard deviation is a measure of the dispersion of a set of data from its mean. If the data points are further from the mean, there is higher deviation within the data set. Standard deviation is calculated as the square root of variance by determining the variation between each data point relative to the mean.
*Significant at the 1% level.
For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment. Small-cap and mid-cap company stocks tend to be more volatile and can be less liquid than large-cap company stocks. Due to market volatility, the market may not perform in a similar manner in the future.
Past performance is no guarantee of future results. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

 

Further, a greater proportion of dividend payers are coming from style boxes other than large value. As shown in Chart 3, over the last 10 years, growth stocks have increased, from 16% to 23% of all dividend payers in the Russell 1000 Index, while value stocks have declined, from 46% to 42% of the total. Meanwhile, mid-caps currently comprise more than 50% of all dividend payers in the Russell 1000 Index (by count). Because Affiliated’s strategic allocation construction process starts with universe construction based on which companies are actually paying dividends, it ensures that the mid-cap and more “growth-like” companies are not ignored. (Remember that dividends are not guaranteed, and may be increased, decreased, or suspended altogether at the discretion of the paying company.)

 

Chart 3. Growth Stocks Have Accounted for a Larger Percentage of Dividend Payers
Percent of all dividend-paying stocks by Morningstar style box for the indicated years

Source: Morningstar.
For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment. Small-cap and mid-cap company stocks tend to be more volatile and can be less liquid than large-cap company stocks. Due to market volatility, the market may not perform in a similar manner in the future.
Past performance is no guarantee of future results. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

 

Sector and Industry Diversity
Just as more growth companies are paying dividends, so too are companies within industries one typically would associate with growth and reinvestment. Information technology companies, for example, now comprise 9% of dividend-paying stocks, versus 6% a decade earlier, while the dividend stalwarts in the utilities sector have fallen to less than 6% of the total number of companies paying a dividend. (See Chart 4.) Another development of note: the yield on dividend-paying stocks in the Russell 1000 technology sector during the 2007–16 period rose, from 0.1% to 1.4%.

 

Chart 4. A Tale of Two Dividend Sectors: Technology Has Surpassed Utilities
Percentage of all dividend-paying stocks (Russell 1000 Index) for indicated sectors, 2007–16

Source: FactSet. Data as of December 31, 2016.
For illustrative purposes only and does not reflect any specific portfolio managed by Lord Abbett or any particular investment. Due to market volatility, the market may not perform in a similar manner in the future.
Past performance is no guarantee of future results. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

A look at the breakdown of dividend payers by sector (as of June 30, 2017) in Chart 5 shows that the traditional dividend sectors that are often used in the “safety stock” trade— real estate, consumer staples, utilities, and telecommunication services—now comprise only around 25% of the dividend universe. The sectors contributing to the universe currently are very diverse, an excellent development for equity income funds and investors that value this diversity.

 

Chart 5. A Diverse Universe of Dividend Payers
Distribution of dividend-paying stocks by sector (Russell 1000 Index), as of June 30, 2017

Source: FactSet. Percentage of all dividend-paying stocks in the Russell 1000 Index from each sector.
For illustrative purposes only and does not represent any specific Lord Abbett product or any particular investment and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

The Value of Diversity
Affiliated’s balanced approach to strategic allocation construction draws from all the dividend-paying sectors. This balance is intended to mitigate the “lumpiness” in active return that sometimes can be associated with equity income.

An examination of the last 18 months provides a prime example of the variability of equity income returns amid changes in interest rates. Chart 6 shows the three U.S. interest rate regimes since the beginning of 2016 in sequence: falling (January 4–July 8, 2016), rising (July 9, 2016–March 13, 2017), and then falling again (March 14–June 26, 2017). 

As seen in the bottom row of the table, the Lord Abbett Affiliated Fund ranked in the 32nd, 39th, and 30th percentile of the Morningstar Large Value category, respectively, through these three distinct moves in interest rates. Many competitors with less careful portfolio construction relied on bond-proxy sector overweights for returns. As such, they were exposed to the interest-rate moves, resulting in wide swings in performance through these periods. Affiliated’s performance through periods of rising and falling rates produces exceptional overall results—over the period January 4, 2016–June 26, 2017, the Lord Abbett Affiliated Fund ranked in the 15th percentile of its Morningstar peer group, despite not finishing as high during any of the individual time periods. (Of course, the portfolio may not perform in a similar manner in the future under similar cicumstances.) 

 

Chart 6. How Did Affiliated Fare Throughout Recent Interest-Rate Moves?

 Past performance is no guarantee of future results. Performance data quoted reflect past performance and are no guarantee of future results. Current performance may be higher or lower than the performance data quoted. The investment return and principal value of an investment in the Fund will fluctuate so that shares, on any given day or when redeemed, may be worth more or less than their original cost. You can obtain performance data current to the most recent month end by calling Lord Abbett at (888) 522-2388 or referring to lordabbett.com.
Instances of high single-digit returns were achieved primarily during favorable market conditions and may not be sustainable over time. Performance during other time periods may have been different or negative.

Source: Bloomberg, Morningstar, and Lord Abbett.
“Bond proxy” refers to the real estate, consumer staples, utilities, and telecommunication services sectors within the S&P 500 Index. “Morningstar Percentile Rank” refers to the Morningstar Large Value fund category. Morningstar percentile rank represents a fund’s total-return percentile rank relative to all funds that have the same Morningstar Category. The highest (or most favorable) percentile rank is 1 and the lowest (or least favorable) percentile rank is 100. Morningstar rankings based on data available as of June 30, 2017; see Glossary for further information.

 

We believe Affiliated’s performance during these periods highlights the value of an approach that is carefully constructed and strictly manages active risk relative to that construction. Lord Abbett’s Calibrated strategies, including Affiliated, limit these active risks as part of the portfolio-construction process, enabling stock selection to drive active returns. This approach has resulted in strong performance for the Affiliated strategy over recent periods and since the inception of the Calibrated approach in June 2013.

 

1The Morningstar style box, a proprietary device of Morningstar, Inc., is a nine-square grid that provides a graphical representation of the "investment style" of stocks and mutual funds. For stocks and stock funds, it classifies securities according to market capitalization (the vertical axis) and growth and value factors (the horizontal axis). The vertical axis of the Style Box defines three size categories, or capitalization bands-small, mid-size, and large. The horizontal axis defines three style categories. Two of these categories, "value" and "growth," are common to both stocks and funds. However, for stocks, the central column of the style box represents the core style (those stocks for which neither value or growth characteristics dominate); for funds, it represents the blend style (a mixture of growth and value stocks or mostly core stocks).

2The final portfolio is then constructed using an optimizer that maximizes the undervaluation, while limiting active sector and factor risks. This undervaluation is determined by our proprietary Evaluation of Stock Prices (ESP) valuation framework, which utilizes our analysts’ projections and consensus estimates to arrive at projected fundamentals for each stock in our universe. The valuation framework then uses current market risk preferences to find a present intrinsic value for the projected company fundamentals in our universe of stocks. By assembling portfolios of securities with high intrinsic values relative to market values, we tend also to have portfolios that are “cheap” by other, more readily available, heuristics, like forward price-to-earnings, for example. All Calibrated portfolios are constructed in this manner and share this tilt to “cheapness.”

 

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The Lord Abbett Affiliated Fund Class A invests primarily in dividend-paying stocks of large U.S. companies. Access performance and portfolio information.

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