When Diversification Fails: This 11.3% Dividend Has A Huge Hidden Cost

Forbes

a day ago

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The media is still obsessed with the 'sell America' trade.
That is, in a word, overblown. But there is something valuable here—especially for us income investors.
Because even though the US has the world's most diverse and dynamic economy, bar none, we do need to make sure we're spreading at least some of our assets beyond a single country or asset class.
For maximum safety (both for our portfolio value and our income streams) we also need exposure to alternative asset classes beyond US blue chips, such as global stocks, real estate investment trusts (REITs) and corporate bonds.
But here's where a potential pitfall lies: Important as diversification is, we can not make the common blunder of letting it take over our investment decisions. That way lies 'locked-in' ho-hum (or worse!) returns.
I think it's better to be a little overexposed to, say, the US (or one specific asset class) and book greater returns than to suffer through year after year of missed profits.
Let's unpack this more using three high-yield closed-end funds (CEFs) that show the right and wrong ways to diversify: The first two are US-focused but have completely different portfolios, with one holding blue-chip stocks and the other corporate bonds.
Taken together, they're a great example of diversification done right.
And we are, of course, talking income here, so I've included a dividend target, as well. In all of the examples we'll get to, we're aiming for a $100,000 yearly income stream.
With, say, a collection of CEFs yielding 7%—an easy-to-get yield with these funds—you can get that $100K in payouts with just $1.43 million invested. That's less than a fifth of what you'd have to pile into the typical S&P 500 stock.
For the most safety, though, we want to diversify so that when one asset class is down, another will pick up the slack. But again, we do not want to become so fixated on this that we let it drag down our overall returns.
Let's start off with what's happened so far this year. The Nuveen S&P 500 Dynamic Overwrite Fund (SPXX), a CEF that yields 7.3%, is about flat, including reinvested dividends as I write this. The fund holds all the stocks in the S&P 500, as the name says, and sells call options on its holdings—a low-risk way to support its dividend.
Meantime, the 14.1%-yielding PIMCO Dynamic Income Fund (PDI), the biggest corporate-bond CEF out there, has returned 8.7% year to date.
Stocks Bonds DIversification
PDI (in purple above) is easily covering its payouts this year, so we have no worries there. But if SPXX (in orange) doesn't recover, it would have to cut payouts or sell stocks—and eat into investors' capital—to maintain them.
But fortunately, SPXX has outearned its payouts, with an 8.2% annualized total return, based on the performance of its underlying portfolio, in the last decade. So there are no worries here, either, for long-term SPXX holders.
This combo, in other words, is an example of effective diversification: The stock and bond picks are working in tandem to deliver a strong average return (better than stocks alone for this year)—and we're getting a 10.7% average dividend, too.
Not bad!
Now let's look at a fund that offers 'one-click' diversification that sounds great—it may even tempt you to simply buy, call yourself 'diversified' and call it a day. But that would be a mistake, since not all diversification is created equal.
That would be another CEF called the Clough Global Opportunities Fund (GLO). It holds the bulk of its portfolio in the US but devotes a large slice to the rest of the world, as well. That differs from SPXX's domestic focus and PDI's US-dollar-centric investments in bonds and bond derivatives.
GLO's geographic diversification is clever, tilting toward US multinationals with foreign consumer bases while also including high-quality international firms like Airbus and ICICI Bank (IBN). Plus, the fund yields a generous 11.3% as I write this. That gets us our $100,000 income stream on just $884,000 invested.
GLO Short Term
Above we see GLO (in blue) nearly matching the top-flight run of our bond fund (PDI, in purple). So GLO's global setup has been a big hit so far this year. That makes sense, as foreign markets have beaten those of the US.
So, GLO is a clear winner for income and diversification, right? Well, not so fast.
GLO Long Term
While SPXX (in orange above) and PDI (in purple) have had strong gains over the last decade, GLO is up a paltry 3.2% annualized, much less than its current yield.
To be fair, this performance isn't entirely the fault of GLO's management: The rest of the world has lagged SPXX and PDI in the last 10 years. But the Vanguard FTSE All-World Ex-US ETF (VEU), in orange below, has nearly doubled GLO. (VEU is a good benchmark for global stocks.)
GLO Underperforms
As you can see, GLO (in purple) was a big winner during COVID and after, but in the end couldn't hold off VEU (in orange). This is why GLO is better avoided, even though it might seem like a good idea in the name of diversification.
The bottom line is that when we diversify, we of course want to set ourselves up for long-term price gains and strong yields. Pairing top-quality stock and bond funds like PDI and SPXX can deliver these. But we do not want stocks or funds that will lag others (and particularly their own benchmarks) by wider and wider margins. That's why I see GLO as a sell.
Michael Foster is the Lead Research Analyst for Contrarian Outlook. For more great income ideas, click here for our latest report 'Indestructible Income: 5 Bargain Funds with Steady 10% Dividends.'
Disclosure: none