Jeff Cullen and Sean O’Hara have a suggestion for investors and financial advisors concerned about post-election uncertainty: Take another look at dividend stocks.
Cullen, managing director of Schafer Cullen Capital Management, and Sean O’Hara, president of Pacer ETFs Distributors, aren’t talking about the sleepy but reliable income-generating equities themselves, but ETFs their firms have created to provide enhanced yields and growth potential.
The two executives spoke at “New Dividend Strategies that Unlock Income and Growth,” a webinar hosted recently by Rethinking65.
Cullen cited five areas of uncertainty and concern regarding the upcoming administration of President-elect Donald Trump: taxes, regulation, tariffs, immigration and geopolitical tensions. “It’s a fluid process,” he said of Trump’s selection of nominees, “and it’s hard to make big investment decisions based upon what-if scenarios.”
But while the direction the administration will take — and how the economy will respond — remain unclear, dividend stocks will remain a reliable source of revenue, Cullen said.
Despite their reliability, dividend stocks typically produce modest yields and are often offered by established companies with little potential for rapid growth. “Why doesn’t Nvidia pay a dividend?” O’Hara said of the Magnificent Seven superstar stock. “Because they don’t have to. Why do utilities pay dividends? Because they have to attract capital. And so, there’s been this forever challenge. How do I get more income from my equity without sacrificing my growth?”
Cullen and O’Hara said their companies’ ETFs boost their revenue stream, Schafer Cullen’s through options, Pacer’s through futures.
‘Starved for Yield’
O’Hara said enhanced-income dividend funds have become more attractive lately. “I believe in my heart that the bond rally of the last 40 years is over for now,” he said. “I don’t see interest rates going back down to zero, but I don’t see them going back up either.”
Investors have been “starved for yield” over the last decade and have looked to alternative investments to get it, he said. Some $7 trillion remains in short-term fixed income, “and if the Fed starts to cut, those dollars are going to try to find a different place to go as well,” O’Hara said.
“So, this is a big opportunity for financial advisors and their clients to start thinking about going forward,” he added.
Another reason to consider enhanced income dividend ETFs is the state of the stock market, O’Hara said.
“I don’t think anybody would argue that the PE is elevated in the market,” he said, referring to equity price-to-earnings ratios. “Today, it’s 22 ½ times on the S&P 500 and probably 32 or 33 times on the Nasdaq 100. Those are high numbers, right?” O’Hara said. “I think people might want to start thinking about what happens if we don’t get those returns, and the returns going forward are lower than the historical average for equities.
“That’s a great environment to add something that has a focus on a dividend or a yield in your equity portfolio to help enhance your total return,” O’Hara said.
Schafer Cullen
Founded in 1983, Schafer Cullen has $24.6 billion in assets under management and offers several U.S., global and international strategies that focus on dividend-paying value stocks. One of Cullen’s core strategies has been to boost the revenue stream of its portfolio of dividend-paying stocks through an options strategy. Schafer first employed the strategy in its managed accounts 13 years ago, then in a mutual fund seven years ago. Since March, the firm has offered the same strategy in an exchange-traded fund, the Cullen Enhanced Equity Income ETF (DIVP), which Cullen described as a clone of the mutual fund.
“As our first foray into this, we looked into launching some of our other strategies as ETFs, but this was the compelling one that we wanted to do,” he said. “It was easier to implement in client portfolios for advisors than separately managed accounts, which get a little bulky, a little hard to use. The ETF is a very easy mechanism to implement across the board.”
While the Schafer Cullen ETF and mutual fund are clones, there are differences, Cullen said. The mutual fund pays out a quarterly dividend, but because most fixed-income investors get monthly distributions, Schafer Cullen decided to pay monthly income from the ETF. The ETF’s fee is also 20 basis points cheaper than the mutual fund — .55 compared with the fund’s .75.
Under its “enhanced equity income strategy,” Schafer Cullen maintains a portfolio of 30 to 35 stocks (currently 32), which are spread over all 11 economic sectors and produce a weighted average dividend yield of 4.3%, Cullen said. He noted that those are qualified dividends, which results in a lower tax rate for non-qualified accounts.
The strategy typically appeals to retirees who want “income generation from their portfolio in a thoughtful way,” and already own a lot of fixed income, Cullen said. “It’s probably less applicable for a younger person who has a long-term time horizon” and wants greater long-term growth, he added.
To generate extra income, the firm selectively writes covered call options on 25% to 40% of the stocks in its portfolio, Cullen explained in a follow-up conversation. Schafer Cullen’s option-writers seek out stocks experiencing high volatility to maximize option premiums, he said. “There’s always some kind of volatility and something going on in the marketplace where people willing to pay these options.”
Most of the time, an option expires unexercised, and Schafer Cullen keeps the premium without selling the stock, but 30% to 40% of the time, the option ends in the money, and stock is called away, he said. In most cases, the firm anticipates further increases in share price and buys back the stock, he added.
The strategy has yielded above 7% gross revenue for the last 13 years, Schafer said. While other investment firms also use an options strategy to enhance income from dividend stocks, Schafer Cullen is different in that it writes options on individual stocks, not indexes, he said.
The strategy offers a tax advantage, Cullen said. The premium on an index option is treated as short-term capital gains, Cullen explained. “Because we have more than half of our income coming from qualified dividends, the lower tax rate makes our after-tax yield much higher compared to other ETFs in this space.”
Although Schafer Cullen’s ETF is a reliable source of income, it’s a complement, not a replacement for fixed income, he said. “Because if the equity market drops 50%, this is equities, so it could drop. It’ll be more conservative, but it still could go down 30%, whereas fixed income tends to have better downside protection,” Cullen said. “They are two different things. You still want fixed income for the conservative nature, but when you look at a high-yield junk bond fund, consider this instead.”
Pacer ETFs
Pacer offers 52 ETFs that follow a variety of strategies. O’Hara said Pacer takes a different approach from Schafer Cullen on its two “dividend multiplier” ETFs, the S&P 500-based Pacer Metaurus US Large Cap Dividend Multiplier 400 ETF (QDPL), and the Pacer Metaurus Nasdaq-100 Dividend Multiplier 600 ETF (QSIX).
“What we do is we separate the price return from the dividend return,” O’Hara said, referencing QDPL, “and we reconstruct the S&P 500 in a way that creates a portfolio that delivers four times the yield of the current S&P 500 dividend. So, if the S&P 500 today has a 1.3% dividend yield, we’re going to deliver 5.2% in income on a portfolio.”
With QDPL, Pacer invests about 85% of the ETF funds in the S&P 500 — the fund’s “growth engine,” he explained. The other 15% is invested in the dividend futures market and is used to multiply yield of the portfolio — by a factor of four in the case of the S&P 500-based ETF, and six times with the Nasdaq ETF, he said.
O’Hara also said his firm’s dividend ETFs offer tax advantages. “The vast majority of the income that we generate — aside from the dividend income that’s taxed as dividends, which are very small part — is not taxed at all,” he said. “It’s little quirk in the tax code in terms of how dividend futures work.”
To match the 5.3% yield on QDPL, or the 4.8% yield on QSIX, a taxable investment would have to earn about 9% to 9.5%, O’Hara said. “We always like to say, it’s not what you earn, it’s what you keep that matters.”
“When you use a strategy like the dividend multipliers, not only do you get an attractive dividend yield and tremendous exposure to that long-term growth, but you get to keep a lot more of what we pay you every year, because the vast majority isn’t taxed at all,” he said.
