2017 is turning out to be a decent year for UK equities. Since we last updated our High Yield System in October 2016, the FTSE 350 has delivered nearly 10 per cent total returns (TR) in sterling terms. Our screened portfolio, by contrast, has achieved a TR of only 3.47 per cent, given weightings to each stock after the last review. Instead of holding a 15 stock portfolio based on our criteria, you could have made a much higher return buying exchange traded funds (ETFs) tracking the FTSE 100 and FTSE 250 indices. The split between the 350 by market capitalisation is about 83.25 per cent FTSE 100 and 16.75 per cent FTSE 250. Buying two index-tracking ETFs in these proportions, we tracked iShares FTSE 100 (ISF) and Vanguard FTSE 250 (VMID) from our Top 50 ETFs, a 9.07 per cent total return would have been cheap and accessible for any private investor.
Why has our system done badly?
The inherent risk in a concentrated approach - the system holds 15 stocks based on their dividend yield and other filters - has been exposed. With one stock in particular dragging the rest of the performance down. Oil equipment and services producer Petrofac (PFC) has become embroiled in scandal and the more than 50 per cent fall in its share price has weighed heavily on the portfolio. Less dramatic losses for Royal Mail (RMG) and Carillion (CLLN) have also been a drag but there have also been some notable successes. The value bias the system has exhibited was rewarded as asset manager Man (EMG) came back into favour as did life insurer Legal & General (LGEN). Continuing the theme of realised value in the broad financial sectors, specialty finance company Intermediate Capital (ICP) also posted a 45 per cent return.
Overall, between 10.10.16 and 20.06.17, seven out of 15 stocks made a loss in the portfolio. Thankfully, the portfolio made profits in excess of inflation but the premium above the yield on gilts is below 3 per cent, implying the system isn't adequately rewarding risk. All in all, you can get a better return for less risk and less cost buying the trackers.
Is the HYS simply 'dumb beta'?
Performance has overall been pretty flat since the system was first resurrected in August 2014 - when it was an even more highly concentrated selection of financial and mining stocks. However, in this time UK stock indices have made record highs, so the costs of rejigging and rebalancing our 15 stock portfolio has been unjustified.
There are other hidden risks - the system takes no account of obligations such as pension fund deficits - and the drawbacks of disposal rules designed to avoid panic-selling are that companies such as Carillion, which are afflicted by pension deficit problems, will only be sold from the portfolio if they are actually forced to cut the dividend.
There are rules to ensure a degree of diversification, although the system has tended to select companies heavily exposed to themes such as property and infrastructure. The system stipulates no more than two companies in any one sector, but we have two housebuilders and two real-estate investment trusts (Reits). The infrastructure investment trusts offer some defensive qualities but in the event of a UK property crash, the portfolio would be vulnerable. The selling rules would make it likely we would hold onto these losing shares, so long as the dividend was not passed or cut. This means that in the short run total returns would take a hit if these sectors were hurt. Another drawback is that by the time companies cut dividends, triggering the sell rules, losses could be substantial.
We mitigate the effects of stocks with negative momentum by only rebalancing winners, so that the losers make up proportionately less of overall holdings. If dividends remain protected then this does mean that we would continue to receive income and then, in theory, benefit from the eventual rebound in price - especially as once the stock had positive momentum we would rebalance more of the portfolio capital towards it. However, in practice, we have still missed out on some early recovery gains.
Sadly, the High-Yield System seems to come up short overall and must take its place on the scrap-heap of failed investment systems. Of course there may be periods, through luck or serendipity, when it does better than the market. We will continue to run the screen on our website and see if it ever does.
Portfolio holdings
| Holding | Price 20/06/17 (p) | DY 20/06/17 | % of portfolio 20/06/17 | Total return 10/10/16 to 20/06/17 | % of Portfolio after rebalance | Last IC view |
|---|---|---|---|---|---|---|
| Royal Mail (RMG) | 441.3 | 5.21 | 6.21 | -7.78 | SOLD | Hold 19/05/17 |
| HICL Infrastructure (HICL) | 164.9 | 4.63 | 6.73 | -0.11 | 6.73 | na |
| Go-ahead Group (GOG) | 1,841 | 5.31 | 5.69 | -1.63 | SOLD | Hold 28/02/17 |
| Imperial Brands (IMB) | 3,571 | 4.48 | 6.49 | -3.86 | SOLD | Buy 3/05/17 |
| Man (EMG) | 152.2 | 4.63 | 6.92 | 37.07 | 6.92 | Hold 27/04/17 |
| Legal & General (LGEN) | 261.4 | 5.49 | 8.24 | 24.88 | 7.17 | Buy 10/03/17 |
| Londonmetric Property (LMP) | 171.7 | 4.37 | 6.36 | 18.01 | 7.17 | Buy 31/05/17 |
| Galliford Try (GFRD) | 1,148 | 7.67 | 5.78 | -5.69 | 5.78 | Buy 3/05/17 |
| Carillion (CLLN) | 196.3 | 9.40 | 5.66 | -16 | 5.66 | Buy 3/03/17 |
| Sainsbury (SBRY) | 254.9 | 4 | 7.65 | 13.43 | 7.17 | Hold 3/05/17 |
| Petrofac (PFC) | 408.1 | 12.96 | 3.31 | -55.38 | 3.31 | Sell 25/05/17 |
| Big Yellow (BYG) | 807 | 2.12 | 7.13 | 14.76 | SOLD | Hold 23/05/17 |
| Intermediate Capital (ICP) | 846.5 | 3.19 | 9.75 | 45.01 | 7.17 | Buy 30/05/17 |
| 3i Infrastructure (3IN) | 192.2 | 3.93 | 7.12 | 5.79 | 7.12 | na |
| Saga (SAGA) | 201.7 | 4.21 | 6.78 | 0.7 | SOLD | Hold 29/03/17 |
| Cash | 0.07 | |||||
| Overall TR (from 10.10.16 weightings) | 3.47 | |||||
| ISF/VMID Split TR from 10.10.16 | 9.07 | |||||
| HYS New Selections | ||||||
| Standard Life (SL.) | 398.4 | 4.97 | na | 17.48 | 7.17 | Buy 9/03/17 |
| Ashmore (ASHM) | 357.3 | 4.66 | na | 1.93 | 7.17 | Hold 20/04/17 |
| TUI (TUI) | 1,142 | 4.66 | na | 9.73 | 7.17 | Hold 16/05/17 |
| Bellway (BWY) | 2,996 | 3.72 | na | 39.12 | 7.17 | Buy 15/06/17 |
| Tritax Big Box (BBOX) | 148 | 4.2 | na | 14.29 | 7.17 | Buy 7/03/17 |
Source: Thomson Datastream & Investors Chronicle
Portfolio changes
A knock-on effect of Petrofac spectacular share price fall is that its subsequently higher yield is skewing the average dividend yield of the portfolio. Companies are sold when they combine negative 12-month price momentum with a yield below the portfolio average, so this has resulted in several companies being sold. We say goodbye to Saga (SAGA), after just one review, as well as Big Yellow (BYG), Imperial Brands (IMB), Go-Ahead (GOG) and Royal Mail (RMG).
The replacements are within our diversification rules but increase the skew towards broad financials. Property is another sector that we have a lot of exposure towards, with Tritax (BBOX) replacing Big Yellow in the Reits sector. We also add a second housebuilder with Bellway (BWY) - this heavy weighting towards sectors is worrying and investors should seriously consider looking at more detailed screening metrics when a simple methodology such as the High-Yield System is suggestion such concentrated holdings (check-out Phil Oakley's excellent piece on housebuilders). TUI (TUI) adds travel and tourism to the portfolio but overall it remains very concentrated. Concentrated is fine if you are comfortable with the risk and confident it will be rewarded. This far, however, the High-Yield system isn't really washing its face in terms of rewarding the risk and costs it would take to pursue it.
High-yield system rules
Stocks are selected from the FTSE All-Share having applied the following screening criteria:
■ Positive 12-month price momentum.
■ Market capitalisation in the top 40 per cent of the universe.
■ Dividend yield not in the top 10 per cent of the universe (this is a quality measure).
■ Dividend cover above 1.5.
■ Remaining shares ranked on dividend yield.
■ Companies sold if they combine negative 12-month price momentum with a dividend yield below the portfolio average; or, if the dividend is passed.
Diversification rules:
■ No new addition can increase the number of companies in one sector above two; and there can be no more than five companies in the broad financial sector (banks, financial services, life insurers).
Rebalancing rules:
■ Portfolio rebalanced every six months.
■ 'Winners only' rebalancing of shares with positive price momentum since the last review.
■ Only rebalance shares where a minimum 5 per cent holding change is required.
