VYM ETF: The Rotation To Value Continues And Why Not 40-60

Thesis

Since we launched our marketplace service recently, many readers and members have asked about the key differences between our portfolio strategy and the more “traditional” strategies like the 40-60 strategy. The reasons are multifold. For example, the 40-60 allocation does not make sense under the current market with low bond rates. Furthermore, the combination of traditional wisdom of a 4% or 5% withdrawal rate and a 60-40 portfolio has a good chance of running out of money if you are looking at a timeframe more than 20 years. These discussions are detailed in our blog article here if you are interested.

This article focuses on the following main reasons. And the remainder of the article will show:

• why we do not use these traditional templates because bonds won’t help as much now, or in the many years to come, as they did in the past.
• why the 40-60 fixed allocation (or any fixed allocation) does not make intuitive sense to us. Fixed allocation strategies work most of the time, but misses extreme market opportunities – which matter the most.
• and why we think a value fund like the Vanguard High Dividend Yield ETF (VYM) or high-quality value stocks as more attractive substitutes for bonds.

Rotation to valuation

As you can see from the following chart, the VYM fund has delivered a decent total return in the past decade but lagged the overall market by a large margin. The fund delivered about 218% of total return (assuming dividend reinvestment) over the past decade, translated into a solid CAGR of 8.1%. The above return was driven by a long secular bull market due to the earnings growth of the underlying holdings in the fund, their valuation expansion, and also dividends growth. However, it has been lagging the total market by more than 75%.

The trend has reversed recently, as you can see from the second chart below. The fund has delivered a leading performance in recent months relative to the overall market (and also the treasury bond too) by a good margin. Its total return has been more than 5% over the past 6 months, while the total market went nowhere (actually lost a little bit).

Next, you will see why we think the rotation to value is just starting. Looking forward, we expect it to keep leading the overall market given its attractive valuation and healthy yield spread above treasury rates.

Valuation still attractive

First, let’s take a look at its attractive valuation. As a large-cap value fund, VYM features a less expensive valuation compared to the currently elevated overall market. As can be seen from the following chart, the fund currently features a PE ratio of 17.9x, compared to 24.3x of the overall market represented by the Vanguard Total Stock Market Index Fund ETF Shares (VTI). It is a pretty significant 17% discount. Compared to the tech-centric fund like the Invesco QQQ Trust fund (QQQ), the valuation gap is even larger. The QQQ fund is currently valued at about 34x PE, almost 2x higher than VYM.

Next, you will see that its valuation is not only attractive in terms of absolute PE but also attractive relative to risk-free rates.

Yield spread at an attractive level

For bond-like equities fund VYM, an effective way to evaluate their valuation with interest rates adjusted is to calculate the yield spread. Details of the calculation and application of the yield spread have been provided in our earlier article. The yield spread is an indicator we first check before we make investment decisions. We’ve fortunately had very good success with this indicator because of:

• Its simplicity – it only relies on the most simple and reliable data points (treasury rates and dividends). In investing, we always prefer a simpler method that relies on fewer and unambiguous data points rather than a more complicated method that depends on more ambiguous data points.
• Its timeless intuition – no matter how times change, the risk-free rate serves as the gravity on all asset valuations and consequently, the spread ALWAYS provides a measurement of the risk premium investors are paying relative to risk-free rates. A large spread provides a higher margin of safety and vice versa.

With this background, you will see below that when adjusted for interest rates, VYM’s current valuation is even more attractive than on the surface.

The following chart shows the yield spread between VYM and the 10-year treasury. As can be seen, the spread is bounded and tractable. The spread has been in the range between about 1.5% and 0% the majority of the time. Suggesting that when the spread is near or above 1.5%, VYM is significantly undervalued relative to 10-year treasury bond (i.e., I would sell treasury bond and buy VYM). In another word, sellers of VYM are willing to sell it (essentially an equity bond) to me at a yield of 0% above the risk-free yield. So it is a good bargain for me. And vice versa.

As of this writing, the spread is about 0.88% as you can see. It is still a level wider than the historical average by a comfortable margin. Such a wide yield spread still provides a healthy cushion for investors against further interest rate rises ahead.

Furthermore, the widespread also suggests favorable odds for a price appreciation in the near term. The next chart shows the two-year total return on VYM (including price appreciation and dividend) when the purchase was made under different yield spread. You can see there is a clear positive trend, indicating that the odds and amount of the total return increases as the yield spread increases. More specifically, the correlation coefficient is 0.82, suggesting a strong correlation. Particularly as shown in the orange box, when the spread is about 1% or higher as mentioned above, the total returns in the next two years have been all positive and very large (ranging from 10% to more than ~40% total return in several cases).

And again, as of this writing, the yield spread is 0.88%, close to the widest level of the historical spectrum, suggesting favorable odds for a sizable price appreciation and a solid total return in the near future.

Why we do not do 40-60

With the above analysis, hope you see why we are not so comfortable with these “standard” templates ourselves now. To summarize, the reasons are:

1. Bonds won’t help as much now as they did in the past

And they won’t help much in the many years to come if you share our outlook. Currently, the 10-year treasury is below 2%, in contrast to an average rate of around 5% in the past. So we do not hold as much bond as traditional templates tell us (e.g., the 40%-60% or the 60%-40% template).

2. The 40-60 fixed allocation (or any fixed allocation) does not make intuitive sense to us.

Fixed allocation strategies may work most of the time, but it misses dynamic allocation opportunities like those revealed by the yield spread above. As a recent example, during the 2020 March COVID crash, treasury yields dropped to a level (as low as 0.6% for 10-year maturity). Yet if you stick to a fixed allocation template, you would still be holding a good portion of government bonds in your portfolio. With our dynamic approach, we ourselves sold pretty all of our bonds at that time given that the VYM yield spread was above 3% at that time.

Conclusions and final thoughts

The VYM is an excellent fund all around. It can serve as the core or complement in any diversified portfolio at a rock-bottom cost. It has delivered excellent performance in the past, and we are confident that its performance will continue given the diversified and high-quality U.S. companies it holds. In particular,

• The rotation toward value stocks has recently started. Despite its leading price appreciation in the past few months, VYM valuation is still only 17.9x PE, a pretty significant 17% discount from the total market and almost only half of the tech-centric NASDAQ index.
• Moreover, its yield spread is 0.88% as of this writing, still close to the wider end of the historical spectrum. Such a wide yield spread still provides a healthy cushion for investors against further interest rate rises ahead and also suggests good odds for solid returns in the near term.
• Overall, we do not see bonds to help as much now, or in the many years to come, as they did in the past. From 1980 to now, the bond market went through a 40-year bull market. The 10-yr rate dropped from 15% all the way to almost 2% now, with an average rate of around 5%. How much can bonds help us from here? In terms of price appreciation, the best bondholders can get in the years to come is for bond rates to drop to zero again, which leads to about a 20% price rally for the 10-year bond.
• Instead, we see high-quality value stocks like those in the VYM fund to be more attractive due to their valuation and thick spread relative to treasury bond yields.

Thx for reading and look forward to your comments!