Striking a balance: Keys to building a diversified portfolio Dividend-paying stocks: A viable fixed income replacement?
Meet the speakers
Amy Chain: “In view of the low yields being paid by bonds, what do you think of using dividend-paying stocks to replace a portion of your fixed income allocation?” Fran, can I ask you to take this question? Fran Kinniry: It’s actually the question we take most often from our investors. The lowyield environment that has existed now since 2008 has really been a penalty, if you will. to those who have been conservative or moderate as an investor. Investors have long been able to have a let’s call it “normal” return for being conservative. But over the last five to six years, we’ve seen money markets hovering around zero and bonds hovering around one to three percent; and that’s concerning because, in the world of, “I need more. I want more,” which is very understandable—that’s a pretty low return. We’re seeing investors even take on more equity risk, go to dividend-paying stocks. We’re hearing all the time dividend-paying stocks are yielding more than treasury bonds.
Amy Chain Moderator
But we’ve done some research on this, and what you see is dividend-performing stocks perform like stocks in the bear market. And what we mean by that is we have funds that we can look at and identify, even at Vanguard, that have higher dividend yields. And in 2008 and 2009, they actually went lower than the S&P 500 and lower than the total stock market. So dividend-paying stocks, the most important thing you have to understand is they are not bonds; and they should not be substituted for bonds. If you want to have an overweight to dividend-paying stocks in your equity portfolio, I would do that with some caution, especially if we’re talking to a taxable audience. Dividends are not really a tax-favored way to invest, so you are leaving some money on the table from taxes. But, certainly, we would not think that dividend-paying stocks are a substitute for bonds, which will hold up or have held up well when equities are under some of their bad environments.
Investing abroad: Currency hedging in international bonds Amy Chain: Do you need international bonds in order to have a truly diversified portfolio? Fran Kinniry: Yeah, I think the first thing you have to think about with international bonds is, is the bond portfolio hedged back to the U.S. dollar or not? And that’s a big difference. The vast majority of bond funds that are out and about today in the investment landscape products are unhedged, meaning that you have not only the bond component but the currency component, the currency fluctuation. And what we see from that is the currency fluctuation is significantly larger than the bond component, and so it actually is a higher volatile asset class. And, really, the role of bonds in a portfolio is really to be a diversifier, (continued on next page)
Fran Kinniry Vanguard Investment Strategy Group
to maybe be a more conservative asset class. And so for the products that are out in the marketplace that are unhedged back to the dollar, it is a much more volatile return stream; and it has not really done the greatest job diversifying equity risk. Amy Chain: So rule number one, look for a hedged fund—not a hedge fund, a hedged portfolio. Fran Kinniry: Right, so rule number one is, first, go underneath the covers to your fund and figure out is this fund hedged back to the U.S. dollar or not? There’s nothing wrong if it’s not, but I would put that in your high-risk bucket, right? So if you really are buying it as a diversifier now, not as a high-risk/high-potential return, really, the unhedged is more of a currency/speculative play; but you really think about it from a building block of a portfolio. We really believe that a hedged bond portfolio—so hedged back to the U.S. dollar, non-U.S. investments—is a good diversifier. Amy Chain: What portion of the portfolio do you believe should best be invested outside of the U.S.? Fra