Do equity income investments outperform growth and income investments?

Equity income is primarily referred to as income that is generated from stock dividends. A dividend is a portion of a company’s earnings that is paid back to shareholders in the form of cash. Equity income investments, therefore, are defined in part by the inclusion of dividend-paying stocks.

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Investors can execute an equity income investing strategy by investing in individual stocks, mutual funds, and exchange-traded funds (ETFs). The portfolio manager for these funds will focus on equity income by ensuring that the underlying stocks are from dividend-paying companies.

While the income generated through dividends is a key part of equity income investing, the dividends are an additional component to capital gains. This is what makes equity income different from other types of income investing.

Before offering investment advice, a financial professional will ask investors about their risk tolerance. This simply means how comfortable they are with the idea that they could lose some, or all, of their principal investment. Investments are generally categorized as growth, growth and income, equity income, and income.

• Growth – This is a category that includes a subcategory such as aggressive growth. A company that fits into the growth category is not paying dividends. Frequently these are mid-cap companies or small-cap companies who reinvest earnings into their business because they are growing. Growth investors are typically younger with a lot of time before retirement. Therefore, they accept the potential losses that come from the market volatility associated with growth stocks in exchange for the opportunity to achieve larger capital gains.
• Growth and Income– In this category, investors start to move from growth by adding some income-producing stocks into their portfolio. However, the focus will still be weighted toward growth.
• Equity Income– This category, like growth and income, focuses on both an increase in principal through capital gains as well as income from dividends. However, in the case of equity income investing, the focus will be weighted towards the income side.
• Income– This category will be heavily into fixed-income securities such as bonds and certificates of deposits. When interest rates are down, as has been the case for much of the twenty-first century, many income-oriented investment plans have started to include some dividend-paying stocks to help generate sufficient income to meet an investor's long-term objectives.

One of the first questions for equity income investors is what types of assets do they want to invest in, and what will the mix between them be?  In many cases, investors will choose to include both individual stocks and equity income funds as part of their portfolio. Depending on their age, investment objectives, and time horizon, investors may choose to start their equity income strategy while still maintaining exposure to a few growth stocks. Likewise, as mentioned above, many income investors have been adding some equity income components to their asset mix in order to generate sufficient long-term returns to meet their objectives.

If mutual funds and ETFs will be part of an equity income portfolio, it’s important to consider whether to invest in the broader market or whether to invest in specific sectors. Choosing an equity income strategy is about risk tolerance not about limiting options. There are equity income funds that focus on distinct sectors. For example, as of March 31, 2019, some of the top equity income ETFs included names such as the Invesco Aerospace and Defense ETF and the SPDR S&P Semiconductor ETF.

Another question to ask is whether to invest in foreign securities. Equity income investments are not limited to the United States. Many investors can find a global equity income fund may be outperforming a fund that is strictly concentrated in one country or region.

While it’s true that this style of investing means missing out on the potential for the potentially large reward that comes from a growth stock, it also means you are exposing yourself to less risk.

Once you’ve decided on your asset mix, it’s important to research them individually to determine which show the most potential to deliver the desired return. Since one of the primary reasons to undertake an equity income strategy is for the dividend, an obvious performance metric to check is the company’s dividend yield. Although some companies may post impressive dividend yields, they should be compared to the average yield in the sector to draw a more meaningful conclusion. In some cases, a high dividend may indicate that a company has no other uses for its cash while other companies in the sector are using cash for research and development.

You can evaluate the risk-return tradeoff of one fund to another. Once again, the stock or fund's prospectus can and should be, a primary source of this information. In the prospectus, investors can find detailed performance metrics such as:

• Alpha – the measure of an asset’s performance on a risk-adjusted basis. The higher the alpha the better.
• Beta – the historical market risk of an asset relative to an underlying index over a period of time. This is also referred to as the beta coefficient. The overall market has a beta of 1.0 so an asset with a beta of 1.0 would be expected to move precisely with the market. A beta higher than 1.0 indicates the asset will most likely be more volatile (both to the upside and downside) as the overall market. A beta lower than 1.0 indicates less volatility.
• Standard Deviation – a measurement of an asset’s historical total risk that assesses the probable range within which the return could deviate from its average return over a period of time.
• Sharpe ratio – a measurement of risk-adjusted performance that tells investors if an investment’s returns are due to smart investment decisions or due to the presence of high risk. One of the reasons investors like the Sharpe ratio is that while one asset may show a higher return than a comparable asset, it may not be a wise investment if those gains came as the result of higher risk.
• R-squared – is a correlation measurement that shows how closely the historical movement of returns relates to a particular index over a period of time. The S&P 500 index is the benchmark for equity and equity funds.

There is also information available regarding the fund’s total return, net asset value (NAV), and the weighted average market cap of the underlying security (or securities). While all of this may look daunting, your investment advisor or registered broker-dealer can help you interpret the data. 

The short answer is that they can, but not always. An equity income fund, for example, poses less risk for investors. Over time, the companies that make up the fund have tended to outperform the broader market. But again, this is measured over time.

There are many factors that go into the overall return for a portfolio. For mutual funds and ETFs, investors should be sure to read the prospectus carefully. The prospectus will review the fund’s investment style and associated risk. It will also include information about total return and risk-adjusted return – which is essentially the risk of choosing one fund as opposed to another. Investors will also get a clear listing of all fees and expenses associated with a fund. The presence or absence of fees (including operating expenses and sales charges) can significantly affect a fund’s return.

You can find a digital version of a fund’s prospectus on the fund’s web site. The prospectus is a legal document that fund companies are required to submit to the Securities & Exchange Commission (SEC) which posts it on their EDGAR database.