John is proud of his son Chad. Last year he landed his first full time job and every month he saves money and invests it. One day they are talking on the phone and Chad says, “Dad, I know you like your dividend stocks, but index investing is really the way to go.”
John replies, “Index investing is great, Chad – as you know I use index ETFs to get exposure to international markets. But for my Canadian equities, my dividend stocks have always treated me very well.”
“Yeah, I know they’ve done well, but an index fund is safer because you own all the companies in the index, not just a handful. By owning fewer stocks you’re taking on more risk.”
“That’s why I stick to blue-chip dividend-payers . . . but I see what you mean. Sometimes my portfolio behaves very differently than the benchmark index. Often that’s positive, but sometimes it under-performs. Overall, I don’t think my dividend stocks are more risky than an index fund, but I have to admit, I’ve never confirmed that.”
You’re probably reading this because you’re interested in growing your wealth. Perhaps you’re familiar with the fact dividend-paying stocks have historically outperformed non-dividend-paying stocks and you’re looking to optimize your own returns. Higher returns = better investments, right?
Well . . . maybe. Those who prefer index investing might point out that by eschewing the broad diversification of index ETFs and purchasing a smaller number of individual stocks, dividend investors are, by definition, taking on more idiosyncratic risk. The reasoning is that higher risk leads to a higher dispersion of returns – i.e. more portfolio volatility.
This is a valid concern – just think about stocks vs. bonds. Stocks are more volatile than bonds so investors demand higher returns to compensate for higher risk. If the risk is not compensated appropriately, the bonds might be better investments.
And so, even if dividend-paying stocks have outperformed their benchmarks, that doesn’t necessarily mean that investors have been adequately compensated. Thus, we need a way to understand investments that incorporates both risk and return. We call this “risk-adjusted returns”, and it’s probably simpler than you think.
What are risk-adjusted returns?
A risk-adjusted return is a calculation of the profit or potential profit from an investment that takes into account the degree of risk that must be accepted in order to achieve it (Investopedia).
Usually the risk of an investment is measured against that of a virtually risk-free investment. We will be using Canada Savings Bonds in our calculations.
How is risk measured?
There are two common ways to measure the risk of an investment: beta and standard deviation.
Beta is a measure of volatility compared to the market as a whole. The term “beta” is often used interchangeably with risk or volatility, but this is misleading. Beta is not a pure measure of risk or volatility, but rather a measure of how a stock’s performance differs from that of the underlying index.
Beta is generally calculated using five-year data. A beta of 1.0 means the value of a stock (or portfolio), on average over the last five years, has moved in lock-step with the underlying index. If the index went up 10%, the stock did too. A higher beta of, say, 2.0 would mean that a stock has, on average, moved twice as much as the underlying index; a 10% rise or fall in the index would be accompanied by a 20% rise or fall in the stock, respectively. Whereas a beta between 0 and 1 indicates returns that are correlated but have lower volatility than the index.
Enbridge (ENB), our highest-yielding BTSX stock, for example, has a 5-year beta of 0.56. Thus it tends to move with the market while being about half as volatile. CNQ has a 5-year beta of 1.39, indicating higher relative volatility than the index. The utilities AQN and FTS have betas barely over zero (0.14 and 0.04, respectively), indicating returns that are hardly correlated with the market at all. I think of such stocks as being almost bond-like.
The average 5-year beta of our current Beating the TSX list shown below.
There is plenty of evidence to show that dividend-paying stocks as a whole have lower beta than non-dividend-paying stocks. This is one of the only “free lunches” to be found in investing: lower volatility and higher historical returns. So far, so good, but we need to dive deeper.
Standard deviation is a statistic that reflects how variable the results within a dataset are relative to the mean of that same dataset. Bitcoin has a huge standard deviation. Fortis (FTS) has a small one. Standard deviations are not compared to a benchmark, rather they are a measure of internal variability.
When measuring the risk-adjusted returns of Beating the TSX stocks, standard deviation is useful in a practical sense because we have access to 30 years of portfolio returns vs only five years of data for beta.
Looking back at the total returns of Beating the TSX portfolios vs the benchmark, we can see that BTSX had higher variability and thus, a higher dispersion of returns.
Interesting. Even though BTSX stocks appear to have lower beta, on average, over the last three decades, portfolio returns have actually been more volatile. BUT, there are two things we must remember that dividend critics often forget:
- Standard deviation doesn’t distinguish between variability that is higher or lower than the mean. Thus, really good years (like 2021) will increase standard deviation and be good for investors – i.e. not all volatility is bad.
- If the portfolio with higher standard deviation has also performed better overall, investors may have been compensated for that variability. This is exactly why we need to understand risk-adjusted returns.
Still with me? Great, because we’re ready for the good stuff.
The most common way to measure risk-adjusted returns
Perhaps you’ve heard of the Sharpe ratio. It measures investment returns against a risk-free rate such as those that investors might receive from treasury or Canada savings bonds. It is calculated by taking the return of the portfolio, subtracting the risk-free rate, and dividing this result by the investment’s standard deviation. The higher the Sharpe ratio, the better.
So, using the standard deviation data above and the historical BTSX performance data, we can finally compare the risk-adjusted returns of Beating the TSX vs. the TSX 60 benchmark. Let’s start with a 10-year Sharpe ratio for BTSX:
Rp = 12.29% (BTSX 10 year average total return)
Rf = 1.76% (current 10 year Canada bond rate)
σp = 17.64%
BTSX 10 year Sharpe ratio = 0.597
Now, we can do the same calculation for the index:
Rp = 8.42% (TSX 60 10 year average total return)
Rf = 1.76% (current 10 year Canada bond rate)
σp = 11.73%
Benchmark 10 year Sharpe ratio = 0.568
What we can see from these numbers is that over the last ten years, Beating the TSX investors have enjoyed not just higher returns, but higher risk-adjusted returns. Just for fun, I calculated the 30-year numbers. Here is a summary:
Using the Sharpe ratio, it would appear that Beating the TSX investors have indeed been compensated for any additional volatility they have endured over the last 30 years. But this measurement actually understates the risk-adjusted benefits of Beating the TSX.
Improving on the Sharpe ratio
The problem with the Sharpe ratio is that it relies on standard deviation as a measure of risk and standard deviation doesn’t distinguish between variability to the upside or downside. When it comes to investing, it’s really downside volatility that is risky. Enter the Sortino ratio, which only considers downside volatility:
By only considering downside standard deviation, the Sortini ratio doesn’t penalize a portfolio that has displayed outsized positive variability – something all investors hope for. However, because we are only using the variability of down years, we only obtain useful results by using our 30-year data. As you can see, Beating the TSX portfolios now appear even stronger on a risk-adjusted basis:
It’s worth noting that there is a good reason for dividend-paying stocks to display lower downside volatility. As stock prices fall, yields of dividend-paying stocks go up, making them more and more attractive to investors. Thus, when markets are falling, dividend stocks tend to be more resilient than non-payers. I call this the dividend shock-absorber effect. This effect explains the lower beta of dividend-paying-stocks, while the slightly higher standard deviation can be explained by the occasional dividend-cutting “loser” and the variability of positive returns.
The bottom line
There are other ways to calculate risk-adjusted returns, but these are the most relevant for our purposes as long-term dividend investors. For me, the evidence is quite compelling: Beating the TSX investors have been more than fairly compensated for any additional risk they might have taken on by owning fewer stocks. In fact, one could easily make the argument that, in the long run, Beating the TSX has been both less risky and more profitable than index investing in Canada.
Risk-adjusted returns - a summary
- Investors must be compensated for taking more risk with higher returns
- Portfolios with different risk profiles can be compared using “risk-adjusted returns”
- There are two common measures of risk/volatility
- Beta measures the volatility of an investment relative to its benchmark
- Standard deviation measures the volatility of a portfolio relative to its average returns over time
- The Sharpe ratio weighs risk-adjusted returns by measuring investment returns against a risk-free rate, adjusting for standard deviation of returns. The major weakness of this metric is that high positive returns are deemed as “risky” as very low returns.
- The Sortino ratio seeks to improve upon the Sharpe ratio by only including downside standard deviation.
- Both the Sharpe and Sortino ratio show that Beating the TSX has outperformed the benchmark ETF on a risk-adjusted basis over the last 30 years.
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