Equity-Income Funds Model

 

Categories, Factors and Filters at a Glance

Categories Selections
Product Type Fund
Asset Type Stock
Track Record 3 Years
Domestic Equity Large Cap, Mid Cap, Small Cap

Criteria K4 Factor Importance
Maximize Yield Expense Ratio Medium-Low
Total Return 3-Year Total Return NAV High
Downside Protection 3-Year Negative Months Lowest
Risk-Adjusted Return 3-Year Sharpe Ratio Medium
Yield Trailing 12-Month Dist. Yield Highest


Filter Limits
Percent in Bonds Maximum Value = 0
Percent in Convertibles Maximum Value = 0
Trailing 12 Month Dist. Yield Minimum Value = 3.5%
Actual 12b-1 Fee Maximum Value = 0

Basis for Model Design

Ever since the mid-1920s, dividend yield has accounted for about two-thirds of the S&P 500’s real return. Although we often think of capital appreciation as the driving force behind equity returns, once inflation is stripped away, it has only contributed half as much as dividends. With the S&P 500 currently yielding a mere 1.7%, dividends are often overlooked in fund selection. There are, however, funds that have consistently boasted above-average yield and superior total return.

Equity-Income Funds are typically preferred by more conservative investors who don’t mind sacrificing a little upside potential for the yield’s downside cushion. Their appeal grew in 2003 when Congress passed legislation granting favorable tax treatment to stock dividends. With economic growth now decelerating, even more investors may see their appeal.

Although Morningstar has no “Equity-Income” category, Klein Decisions’ K4 Fund Selection can still help you evaluate Equity-Income Funds. This model rewards funds with strong dividends by requiring a minimum yield of 3.5%, roughly twice that of the S&P 500. To maximize net yield, expense ratios should be minimized and there should be no 12b-1 fees. Total Return NAV and the Sharpe Ratio serve as measures of total return and risk-adjusted return. The number of negative months over the past three years gives a perspective on downside protection. Since many Equity-Income Funds were launched after the 2003 tax act, the minimum track record is limited to three years. Finally, because this is an analysis of stock funds, holdings cannot include bonds or convertible securities.

Step By Step Guide

  1. Begin by selecting "Create New Scenario" and give it the name "Equity-Income."
  1. On the next screen, leave "Fund" for the Product Type and "Stock" for the Asset Type. Change Track Record to "3 Years" to limit the analysis to funds with a minimum of three years' history. Click on "Update Classes."
  1. On the next screen, select "Domestic Equity;" this will place checks next to all capitalizations and styles. Click on the "Update Selections" button at the bottom of the page; when it updates, click on the "Save Selections" button at the bottom of the page.
  1. Click “Continue” on the next two screens to bring you to the Attribute Selection page.
  1. Select the following K4 factors to reflect the associated investment criteria:

 

Criteria K4 Factor Importance
Maximize Yield Expense Ratio Medium-Low
Total Return 3-Year Total Return NAV High
Downside Protection 3-Year Negative Months Lowest
Risk-Adjusted Return 3-Year Sharpe Ratio Medium
Yield Trailing 12-Month Dist. Yield Highest

  1. Click "Continue" to answer the importance questions on the next page and the trade-off questions on the following page.

  1. On the Results page, click on "Add" to the right of Filter Status. Hold down the control key and select "Percent in Bonds," "Percent in Convertibles," "Training 12-Month Dist. Yield," and "Actual 12b-1 Fee." Click on "Add Filter."

  2. Enter "0" as the Maximum Value for Percent in Bonds, Percent in Convertibles, and Actual 12b-1 Fee, and "3.5%" as the Minimum Value for Trailing 12-Month Dist. Yield. Click on "Apply Filters" at the bottom of the page. This will take you back to your filtered results.

After applying the filters, the highest ranked funds are those with above-average yield and risk-adjusted returns over the past three years. Notice that “12-Month Dist. Yield” is used both as a preference item and then again as a filter. It is used as a preference to reward funds with greater yields while as a filter it sets the minimum yield to be considered, in this case 3.5%.

Although this scenario covers all domestic equity capitalizations, it might intuitively seem that all top-performing Equity Income Funds would come from Large Cap Value. That, however, wasn’t the case when this model was run using June 30, 2007 data. At that point, nine funds survived the rigorous filters, with only three coming from Large Cap Value. Of the remainder, two were in Large Cap Blend, one in Mid Cap Value, two in Small Cap Value, and one in Small Cap Blend. Dividend stocks and the funds that buy them can obviously be found in all capitalizations.

 

To Monitor Future Performance

When new month-end data arrives and you next want to update the scenario:

  1. Click on “Back to Scenario Management” just below “Category Selection” at the top left of the page.

  2. Locate your original scenario (Equity-Income) in the current folder and click "Change Name." On the next page, rename the scenario "Equity-Income XX/2007" where "XX" is the month-end (e.g., "06" for June) for the data in the original scenario. This file will remain as your record of the scenario with June 30 data. Click continue. This will take you back to the original folder in Scenario Management.

  3. Locate the scenario you just renamed (Equity-Income XX/2007) in the current folder and click "Copy." On the next page, rename the scenario, "Equity-Income YY/2007" where "XX" is the month end of the most recent data (e.g., "09" for September). This will be the scenario with the current month end data. Click continue. This will take you back to the original folder in Scenario Management.

  4. Locate the scenario you just renamed and click on "Edit." On the next page, click on the "Results" tab at the top of the page to go directly to the new updated rankings.

  5. Steps 1-4 can be repeated after each month end (or whatever measurement period you wish) to establish an ongoing archive of Equity-Income Fund rankings.