Does higher income always mean lower growth?

TD Asset Management speak on evaluating and rethinking the traditional relationship between growth and income.

In the world of investing, nothing is static. Theories and strategies that brought us success in the past may not always provide prosperity in the future. This year, global investors faced volatility of epic proportions as markets plunged to depths unseen in many years, only to recover much of the losses. With central banks around the world providing enormous amounts of stimulus to help the economy, asset managers need to pivot and think about new ways to generate returns. This includes evaluating and rethinking the traditional relationship between growth and income.

The balance of growth and income

Investors that traditionally relied heavily on bonds for income returns are now facing increased challenges to generate enough income as yields continue to be suppressed and are expected to stay lower for even longer. Against this backdrop, negative yielding bonds now account for around 20% of total bonds outstanding, which means they are guaranteed to lose capital if held to maturity.On the equity front, higher yielding stocks don’t often offer growth, and high growth stocks don't often pay dividends. Therefore, investors could run the risk of eroding capital upside by chasing yields on low growth equities.In the face of COVID uncertainties and geopolitical tensions, how does one balance growth and income? The answer could be found in an enhanced dividend strategy offered by TD Asset Management ("TDAM").

What options are available for this conundrum?

Launched just over a year ago, TD Active Global Enhanced Dividend ETF (TGED) was designed to resolve the specific challenges of balancing growth and income in the search for yield. The strategy behind addressing this challenge is to generate highly attractive income through a differentiated option overlay strategy. TGED, unlike many competitor products, uses a completely active approach in both selecting stocks and writing options.

This approach not only allows TGED to enhance income on high quality underlying stocks, regardless of whether they pay dividends, but does so without sacrificing long-term capital growth. Having said that, the ETF does not simply replace growth with yield, but rather focuses on total return. What's more, investors may benefit from a tax perspective as the collected option premiums are generally characterized as capital gains rather than income.

TGED seeks to deliver 4%+ annual yield to investors while investing in global high-quality businesses that are tied to secular growth trends and can compound free cash flow over time.

The benefits and shortcomings of a systematic covered call strategy

A popular investment strategy to generate additional income in an equity portfolio has been a systematic covered call strategy. If history is a guide, a covered call strategy can typically outperform in a sideways or downward trending environments. The chart below helps illustrate this relative performance. It depicts the yearly performance of the S&P 500 Index versus the same Index overlaid by a systematic covered call strategy, with the assumption of writing 2% out-of-the-money covered calls and resetting these options every month.

The systematic covered call strategy enhances the income in a portfolio by capping growth up to a 2% monthly gain in exchange for current income (i.e. the option premiums). During periods of lower volatility, this systematic strategy generates solid risk-adjusted return as the additional income enhances the portfolio appreciation if monthly market returns remain below 2%. However, if the market trends higher, as we have seen over the past decade, the systematic covered call strategy will still enjoy growth but can significantly lag the performance of the overall market.

Based on this dynamic, investors should expect that a systematic covered call strategy can add value in a weak market, but will underperform in a strong market. However, for TGED, the active ETF has demonstrated that it can add value in both market downturns and market rallies using a proprietary active covered call writing strategy.

How TDAM does it differently

At its core, TGED leverages the TDAM time-tested philosophy and process when selecting underlying stocks. The ETF would only own high-quality businesses that have sustainable competitive advantages, solid balance sheets, compounding free cash flows and be set to better weather difficult times like the first quarter of, 2020, and thrive in the long run.

In addition, TGED outperformance was attributable to our active approach to writing options rather than a systematic approach. Unlike systematic option strategies, we are very selective on timing, underlying holdings, strike prices, expiry dates and contract sizes. Each of these factors are analyzed based on thorough fundamental research of a particular business at that moment in time. In scenarios like February 2020 when volatility spiked, we could terminate an option contract earlier than maturity and start a new one at a much more attractive yield. While it requires significantly more work than a systematic approach, we aim to generate high income for investors today while keeping their long-term capital growth in mind.

On balance, TGED is in a unique proposition to tilt the balance of income and growth in the investors' favour. The ETF only holds high-quality businesses and uses an active approach to enhance income without sacrificing total return. Looking ahead, when facing the uncertain impact of COVID-19 on the global economy and the ongoing geopolitical risk, TGED can stand to benefit from a volatile environment as, generally speaking, the higher the volatility, the higher the option premiums and by extension, the more opportunities for an active investor.

Following the success of TGED, we are excited to have recently launched the TD Active U.S. Enhanced Dividend ETF (TUED), that uses the same active strategy and focuses purely on U.S. equities.