Investors—pension fund investors in particular—remain skeptical of a reliance on the equity risk premium. Judging from the asset mix trends and money remaining on the sidelines, many appear to have very limited expectations for stock performance in the next few years.

After the market experience of 2008, Canadian equity markets, as measured by the TSX Index, rebounded with annual returns of 35.1% in 2009 and equally strong returns of 17.6% in 2010. However it would appear that 2011 is off to a rocky start (it is down 1.4% so far in January and the “January effect” would suggest that this might portend a poor year overall!. And in a year-end survey, Towers Watson reported lower than normal projections from survey participants for the expected recovery in economic growth over the next few years.

Some industry observers are cautioning that unless there is a sharp recovery in economic fundamentals, stock returns in developed markets may continue to be constrained and that we could be in for another substantial market correction in a few years. Granted, these comments are made by perennial bears but global GDP growth does appear to be shifting towards emerging markets, which is a topic for another day.

Despite these market conditions, it still makes sense to maintain a full exposure to equities. The rationale for this lies with some basic investment wisdom—when taking risk, take it in asset classes where you have some upside to counteract your downside. This view is all the more relevant when one compares current dividend yields with corporate bond yields from the same issuer.

The Merrill Lynch US Corporate AAA bond yield is at a 14-year low, and the dividend yield has remained relatively high compared to historical averages. In late 2010 these indexes crossed each other with the dividend yield moving marginally ahead of the AAA yield. This is also apparent at the individual stock level, with more than half of the largest S&P 500 companies by market cap, such as AT&T, Philip Morris, Bristol Myers and Pfizer, having dividend yields at or exceeding their bond yields.

So why not purchase blue chip dividend yielding stocks as a substitute for corporate bonds in this environment?

Larger funds may prefer to look at alternative investments or hedge fund strategies to take advantage of these market anomalies. A creative hedge fund manager could no doubt construct all manner of strategies to take advantage of these conditions.

Smaller funds however need a “simple” solution to their asset mix strategy. Stocks, and their equity risk premium, still offer the best information ratio when one takes into account both market risk and operational and governance risk. (This is admittedly not the classic definition for an information ratio, but small funds need to factor in all these risks).

How can investors access a well diversified portfolio of blue chip quality stocks?

  1. In the U.S., there are a number of managers with a solid track record in dividend yielding or earnings quality stocks. Management fees are typically 50 to 60 basis points, so an incremental return objective well in excess of 1% should be targeted. For these mandates, value added targets have been more impressive given their unique characteristics.
  2. Passive mandates can also be secured using a number of indices as the reference benchmark. These include the Dow Jones US Select Dividend Index (DJ Dvd), the Russell 1000 Dividend Achievers Index (R1000 Dvd) and the S&P 500 Dividend Aristocrats Index (S&P Dvd).
  3. For the more adventurous investor who has the ability to manage their own securities, there is research available in the retail world as to how to identify a portfolio of high dividend stocks with the potential to outperform. For a Canadian mandate, such a portfolio would include names like Biovail, Canadian National Railway, Canadian Utilities and major Canadian banks.

In short, keep it simple. In today’s market uncertainty there are many interesting—and complex—alternative investments out there. However for a core portfolio holding, may’be the old chestnut of equity valuations being equal to the present value of future dividend payments holds some wisdom for us.