Summary - Equity income investing involves the purchasing of securities that provide income from dividends along with the opportunity for capital gains. An equity income portfolio can include individual stocks as well as mutual funds and exchange-traded funds (ETFs). Equity income investments allow for some growth. However, the companies tend to be more mature and established. They are likely to have a higher market capitalization than pure growth-oriented stocks. This means that they generate large amounts of earnings that they are looking to distribute to shareholders in the form of regular cash payments.
While it does include elements of both growth and income, from a risk tolerance standpoint, equity income is a conservative, long-term investment strategy. A true growth and income fund will put their emphasis on growth first, and then use equity income assets to provide a hedge. In the case of an equity income fund, the emphasis is on generating dividend income first with capital gains to ensure the investments keep up with the cost of living.
Every investor loves the thrill of watching their portfolio increase in value. Even if it’s just one stock or fund that is rising, the goal of investing is to see assets appreciate in value.
However, the increase in the value of a capital asset (i.e. a capital gain) is only realized when the asset is sold. In the meantime what comes up will often come down. And when it does, it can erase all the gains an investor has made.
An alternative for some risk-averse investors is to execute an investment strategy that allows them to generate some capital gains while providing an additional source of income through the payment of dividends. Among the many benefits dividend, stocks offer is the equity income they provide.
In this article, we'll take a closer look at the topic of equity income. We'll define what it is and where it fits with other types of investment strategies in terms of balancing growth and income. We'll also review why – in some cases – an equity income strategy may produce a higher overall return over time.
What is equity income?
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.
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.
How does equity income fit into an investing strategy?
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.
How to plan an equity income strategy?
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.
Do equity income investments outperform growth and income investments?
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.
Tax benefits of equity income investing
One of the many benefits of dividend investing is in how investors are taxed. For the most part, dividends received from the purchase of common stocks are considered ordinary dividends. Ordinary dividends are considered to be short-term capital gains and will be taxed under ordinary income tax rates. Qualified dividends meet certain requirements and are taxed at the long-term capital gains tax rate. This could be 0%, 15% or 20% depending on income and filing status.
The final word on equity income
Investing in equity income stocks, mutual funds, or ETFs is a conservative investment option that still allows for some capital gains. Most securities are concentrated in two areas: growth or income. In the case of equity investing, an investor is getting both. The difference is in the concentration of growth to income.
The key to an equity income strategy is the payment of dividends. Dividends provide the investor with a regular source of income. Dividends offer many benefits, one of which is that they are typically taxed as ordinary income, meaning investors can avoid the long-term capital gains tax rate.
It’s important to note that choosing an equity income investing strategy is about risk tolerance not about limiting investment options. Equity income investors enjoy many of the same investment options as growth investors. From sector funds to international funds that offer exposure to foreign stocks, investors have many options from which to choose.
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One thing every investor needs to learn is the effect of capital gains on their investments. Every time an investor sells a stock that has appreciated in value, that capital gain is subject to being taxed. Stocks that are held for less than a year pay a short-term capital gains tax rate. Stocks that are held for over a year pay a long-term capital gains tax rate.
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Investing in dividend stocks is never a bad idea, but at times when the capital gains tax rate is favorable, growth stocks provide a better reward for investor capital. But when long-term capital gains tax rates go up, those gains can get expensive.
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