Income-focused investing often leaves too much on the table, says Kathmere CIO

Key Concepts

• Market Volatility: Fluctuations in financial markets, impacting investor sentiment and strategies.
• Risk Tolerance: An investor’s capacity and willingness to accept potential losses in pursuit of higher returns.
• Rotation Strategy: Shifting investments between different sectors or asset classes based on market conditions.
• Covered Calls: An options strategy where investors sell call options on stocks they already own to generate income.
• Yield Smart vs. Yield Trap: A strategy prioritizing attractive income with potential for capital appreciation versus solely maximizing yield, potentially at the expense of growth.
• Total Return: The overall return on an investment, including both income (dividends) and capital appreciation.
• K-shaped Economy: A situation where economic recovery is uneven, benefiting some segments of the population while leaving others behind.
• VIX (CBOE Volatility Index): A measure of market expectations of near-term volatility conveyed by S&P 500 index option pricing.

Market Sentiment and Investor Behavior Amidst Volatility

The discussion centers around recent market volatility and its impact on investor psychology. While volatility has increased, particularly in the large-cap tech sector, overall market performance (S&P 500) has remained relatively flat year-to-date. Notably, both Cathmir and Amplify have not observed a significant shift in the tone of questions from their clients. This is attributed to proactive risk assessment and planning conducted in late 2022, focusing on understanding client goals, risk tolerance, and liquidity needs. Clients were prepared for downside volatility after a strong three-year run, and many feel comfortable with their current investment plans. Value stocks, small caps, and international markets have performed well, contributing to positive overall client sentiment.

Rotation Strategies and Sector Performance

A key observation is the rotation occurring within the equity market. Instead of widespread selling, investors are shifting capital out of previously high-performing mega-cap tech stocks and into sectors like energy, materials, precious metals, and dividend-paying equities. This rotation is driven by concerns about capital expenditure and valuation of tech companies, coupled with the attractiveness of value-oriented sectors. International markets are also gaining traction due to lower valuations and global infrastructure spending. Amplify has seen significant inflows into funds focused on high-quality dividend payers, particularly those employing covered call strategies.

Covered Call Strategies and Income Enhancement

Amplify’s funds utilize covered call strategies to generate income in addition to dividends. These strategies involve selling call options on underlying stock holdings, providing a yield of approximately 5-6% (2% from dividends, 2-3% from options). Their US High Quality ETF (DVO) has gained over 5% YTD, while the international version (IDBO) has gained over 12%, outperforming the broader market. Amplify differentiates itself by adopting a “yield smart” approach – prioritizing attractive income while preserving potential for capital appreciation – rather than solely maximizing yield ("yield trap"). Covered calls are typically written 5-10% out of the money, focusing on a limited number of stocks within a diversified portfolio to allow for continued upside potential.

ETF Industry Flows and AUM Growth

The ETF industry as a whole experienced a 31% growth in Assets Under Management (AUM) last year. Amplify, however, saw a more substantial 70% AUM growth, largely driven by inflows into their covered call and income-focused products. This indicates a growing appetite for income-generating strategies, particularly among investors seeking to navigate market uncertainty. Amplify’s “yield smart” approach has resonated with investors, delivering higher total returns compared to ETFs solely focused on maximizing yield.

Macroeconomic Context and Volatility Regime

The current volatility regime is characterized by relatively low VIX levels and stable high-yield credit spreads, suggesting a resilient economic environment. The US economy has demonstrated 2% GDP growth and a fully employed labor force, supporting corporate profitability (13% year-over-year earnings growth). This resilience has limited broad market volatility, despite sector-specific rotations. The discussion also highlights the historical pattern of midterm election years, typically experiencing a drawdown followed by significant capital appreciation in the subsequent 12 months.

Consumer Sentiment and Shifting Investment Focus

Despite positive economic indicators, consumer sentiment remains surprisingly negative. This paradox is attributed to the “K-shaped economy,” where upper-income consumers are thriving while lower-income households struggle. This divergence is influencing investment decisions, with investors seeking refuge in traditionally safe havens like utility stocks and consumer staples. However, even these sectors are facing pressures, as evidenced by General Mills’ recent warning about consumer stress. The shift away from mega-cap growth stocks is also linked to concerns about their transition to capital-intensive business models.

Portfolio Tilts and Future Investment Trends

Amplify’s models are currently tilting towards international stocks (due to lower valuations and global spending) and natural resource-focused dividend income ETFs (yielding over 10%). Specifically, investments in oil, gas, chemical stocks, silver miners, and high-quality dividend payers are gaining traction. The emphasis remains on balancing income generation with capital appreciation, avoiding strategies that prioritize yield at the expense of growth potential.

The Importance of Total Return

Nick, representing an investment advisory firm, emphasizes the importance of a total return approach to investing. He cautions against solely focusing on income, as it can lead to portfolio distortions and missed opportunities. Systematic or ad hoc sales of portfolio holdings can be used to generate dividends with greater tax efficiency. A total return approach considers both income and capital appreciation, providing a more holistic view of investment performance. He stresses that understanding a client’s goals and risk tolerance is paramount in constructing a well-balanced portfolio.

Conclusion:

The discussion reveals a market navigating moderate volatility with a shift in investor behavior towards rotation strategies and income-generating investments. While panic selling has been limited, investors are actively reallocating capital to sectors offering value, dividends, and potential for capital appreciation. The “yield smart” approach, prioritizing both income and growth, is gaining prominence, as is the importance of a total return perspective in portfolio construction. The resilient economic environment and historical patterns associated with midterm election years suggest a cautious optimism, but ongoing monitoring of consumer sentiment and macroeconomic trends remains crucial.