It was good times for dividend equities throughout 2021, even in the face of a host of worries such as rising inflation, supply chain disruptions, the looming end of QE, and new virus variants. Through it all the Russell 1000® Value Index, often used as a benchmark for large-cap dividend payers, finished up more than 25% for the year and made several new all-time highs in the fourth quarter. 

But once again in early 2022, equity volatility spiked. Stocks, including high-dividend payers, were on the defensive. Although we certainly don’t anticipate a repeat of 2020 when so many companies were forced to cut dividends to preserve cash in the early days of the pandemic, the recent volatility serves as a powerful reminder.  

Dividend strategies might be able to help investors capture attractive investment income to supplement traditional bonds, but it’s important to allocate in a risk-aware manner and be prepared for possible drawdowns. After all, the headwinds facing equities, including the future trajectory of the pandemic, have not disappeared. 

Dividends with Downside Protection?

Income-oriented investors want to know the best way to capture dividend income while managing equity risk. Or put another way: Is there a way to comfortably invest in dividend payers with less worry about high valuations or steep drawdowns?

Those investors concerned with the above may wish to investigate a category of products often referred to as Bear Market or Long/Cash funds, which can toggle their asset mix back and forth between dividend equities and cash. These Bear Market (Long/Cash) funds generally adjust stock/cash allocation up and down based on market conditions . When markets fall precipitously, these funds can shift a portion of equities to cash, and upon further declines, the fund can re-invest in equities. 

Investors seeking exposure to high-dividend-yielding, large-cap U.S. stocks could use one of these funds to help maintain a disciplined investment approach to managing equity risk. These funds aim to lower equities exposure in challenging markets, but in times of lower volatility they tend to remain fully invested in equities. This shifting of allocations can be done systematically based on predefined rules, thus removing emotional decision-making that can plague investors in tumultuous periods. 

Manage Risk Holistically

It’s easy to see why seeking alternatives to traditional bond income—including dividend paying strategies—might be appropriate in the current environment. It’s not just about low yields. Some investors are worried about lower future return expectations of a traditional investment portfolio, so they may be apt to increase their equities allocation. That may or may not be appropriate. But if one ultimately chooses to reallocate to dividend equities, the manner in which it is done can make a big difference. For example, swapping fixed income assets that carry a low historical standard deviation (a popular measure of risk and volatility) with a group of dividend equities will change the volatility profile of an overall investment portfolio. 

When shifting assets within a portfolio in an attempt to capture greater income, investors must keep a close eye on their overall risk budget. Thus, while taking assets from your traditional bond allocation and shifting a portion of those to a dividend-paying strategy may achieve one goal—increasing income potential—it is also likely to elevate the risk profile of the entire portfolio. 

With that in mind, anyone seeking exposure to high-dividend-yielding, large-cap U.S. stocks might wish to consider a nuanced approach. Dividend strategies that manage risk systematically by shifting to cash when volatility rises have the potential to reduce the overall volatility profile of an equities portfolio. This may help investors comfortably gain (and maintain) exposure to dividend paying equities, but with added protection if we run into another extended period of turmoil.