Episode 289: The Dividend Edge: Balancing Yield & Risk in Insurance Portfolios

 

Stewart: Welcome to another edition of the InsuranceAUM.com podcast. My name's Stewart Foley and I'll be your host. Hey, welcome back. It's great to have you and thanks for listening. I just kind of want to touch base with everyone and a quick update on our Philadelphia event that's coming up on May 7th and 8th this year. The focus there is BF Real Estate and Infrastructure. We have four LP spots left and that's pretty much it. So, if that is your jam, these are your people, you can email us at events@insuranceaum.com and we'll get a registration packet to you provided that you're an LP at an insurance company. That's our focus for that event and I look forward to seeing you. We've got a great bunch of folks already committed. We've got a couple of fun Philly-based things for that one too. So all good.

We've got a terrific podcast for you today and it's a little different than what we normally do. This one is called the Dividend Edge Balancing Yield and Risk in Insurance Portfolios, and we're joined today by Michael Hunstad, Deputy CIO and CIO of Global Equities. And Jeff Sampson, Senior Portfolio Management for Global Equities at Northern Trust Asset Management. Gentlemen, thanks so much for taking the time and we're looking forward to a really terrific educational podcast on equities today.

Jeff: Thank you for having us.

Michael: Thank you.

Stewart: What would be helpful I think is, and this is a little bit of a departure from what we normally do, but it would be helpful I think to just give us a little bit of background sort of college to where you are today. And the reason for that, and I mentioned this in our pre-call, is that I'm always mindful of folks who are earlier in their careers and when you get to be as senior as you both are, at least for me when I was in school, it didn't seem attainable. And so Michael, you're a repeat guest, and thanks for coming back on. Could I start with you?

Michael: Yeah, absolutely. And thanks for having me a second time around. I started my undergraduate education at a very small school in the middle of nowhere in South Dakota. I went immediately after that to business school at Purdue, earned an MBA, went the direction that most MBA students go–and they go into consulting, or did at the time–spent a couple of years in consulting, then decided to go back to school pursue a PhD in Mathematics. Out of that, then actually I got a job with an insurance company. I got a job with Allstate Investments in their quantitative group. Spent a few years there, did a couple of other stints in algorithmic trading at a hedge fund, and now have been at Northern Trust for about 13 years. Started in their quant group here and now the CIO of the equity team.

Stewart: That's a great story. We've got some friends over at the Allstate Investment Group. A quick shout-out to those folks. Hope you're all doing well in Chicago.

Michael: Of course.

Stewart: So Jeff, how about you?

Jeff: I'm originally from just outside of Detroit in Michigan, and I wanted to leave the state for college and meet some new people. I went to the University of Wisconsin Madison, so not far from here in Chicago. And after school moved to the big city, moved to Chicago, and I did find my way all those years ago to Northern Trust. So I've been at Northern Trust for my entire career and as a young person starting out at a big organization like Northern Trust, I started in operations—a very nuts and bolts kind of job, learning the organization, and importantly meeting a lot of bright people and learning from them along the way. I went to business school, University of Chicago, and ventured into the CFA program, got my CFA charter, and that sort of drove me more to the investment side of the business and Northern Trust being the company that it is, offering opportunities within, I was able to advance in the firm and make my way over to the equity group and have been there for 15 plus years working on a whole bunch of different strategies.

Stewart: That's super cool. I'll back you up on a lot of smart people at Northern Trust and we've had several guests on and it's always been informative and it's always been a lot of fun. So with that as a backdrop, please allow me to ask the first question, which is Northern Trust Asset Management has deep experience across a wide spectrum of asset classes. Could you share your thoughts on why insurers who are traditionally heavily focused on fixed income should seriously consider public equity exposure and what are the most critical considerations that they've got to address when incorporating those equities?

Michael: Yeah, I'll give it a shot. So Northern Trust Asset Management, we're a full-service asset manager with about $1.3 trillion in AUM. A lot of insurance clients in our book, to your point, Stewart, yes, they're traditionally very heavily fixed income-oriented depending on the kind of insurer, but there's a lot of equities out there too. So if you're a life insurer, you're very heavy on the fixed income. You like the idea of easing your liabilities through fixed income and the stream of payments that come from those portfolios makes a lot of sense. A lot of insurance is about reducing your surplus volatility, which is the difference between your assets and your liabilities. And if you can offset that through a ALM asset liability management or LDI liability to feasance kind of strategy, it makes a lot of sense. So a lot of fixed income, a lot of bonds on the life insurance side, certainly had that at Allstate as well, but property and casualty, and health insurers are very different in their portfolios.

On average, they have roughly about a third of their asset allocation into public equities, and that's largely where we come into play. So, when you think about portfolio construction in some of these types of insurance clients, obviously it's a third of the portfolio, but probably the biggest risk in the portfolio overall and biggest tail risk in terms of what it can do on a day-to-day basis to performance. So you have to think very holistically about how to manage those risks in the portfolio, and that's a key element of what we provide to our clients. The other thing that is really, really important is that some insurance clients are taxable, which means that you need to think about the tax side of the equation as you implement your portfolios and then manage them as time goes on. You think about alpha in the investment world, we always think about beating a cap-weighted benchmark.

If you're really, really good at generating alpha in the large-cap space, you can earn an information ratio or return per unit of risk of about 0.5. If you're really, really good in generating tax alpha, you can earn an information ratio of about 4.0. So it blows away the information ratio you can get from a pre-tax product. So that's just one element of what we do is we provide that tax consideration and tax overlay, but a lot of it's about how do you select your equity investments given the type of portfolio that the client actually employs.

Stewart: That's super helpful. We had one of your colleagues on who leads that effort, the tax advantaged equity strategy. I would just refer to our audience to that podcast if that's of interest as well. So dividend-paying stocks have been appealing for the insurance industry. They really like the income, especially given the dividends received deduction, and you can bring us up to speed on that, but what risks should insurers be particularly mindful of when they're pursuing a dividend-oriented strategy?

Jeff: I think I can take that one thing, Stewart. We certainly saw in a post-GFC world, a low-rate environment that dividend equities were very attractive not only for insurers but just broadly speaking across the markets. And when you're thinking about that space of the market, if you're investing looking strictly at yield, you have to be mindful and really use caution when viewing the market in that way because if you're ranking by yield looking at higher dividend-paying stocks, you tend to get portfolios that have exposures that can be quite different from the market overall that can bring in some unintended biases into the portfolio. You get issues like sector concentration, where a lot of your investments are in traditionally high dividend-paying parts of the market—utility stocks, consumer staple stocks, your telecommunication stocks–so you have that sector exposure. You can have some industry exposure, you can have interest rate risk within the equity market, which could be a reason why an insurer would actually want to come to the equity market, which is to say to mitigate that interest rate risk they have over on the fixed income side.

So knowing there are these exposures that kind of come along with dividend yield as a factor, we think it behooves investors to be mindful of those things, manage those exposures. And the irony is that in the post-GFC world, when rates were really low, dividend equities as a group tended to actually underperform the market. So there's the narrative of investors flooding into stocks and buying higher-yielding stocks didn't necessarily lead to stronger total returns. We know that the QE era was marked by high-growth companies, tech companies, tech-adjacent companies having strong total returns, and that factor of cash returns coming back to investors wasn't necessarily rewarded per se. However, if you approach the space with a total return lens to it, meaning yes, I could want that dividend yield, that's important to me, I like that cash flow, but I also want to focus on price appreciation, the total return of the portfolio… Viewing it through that lens and even a risk lens versus public markets in general, and benchmarks and indices, will take you into a part of the market where you say, okay, I need to diversify here. I need to invest across the entire market in order to manage those risks that I was describing before. So that has served us well in our strategies. That's how we've approached it. Yes, you want to grab that income, you want to look for yield, but you want to take it from a total return perspective.

Stewart: That's super helpful. And Jeff, I think this one goes to you, but there seems to be a little bit of a change in the market environment. You've noted some surprising shifts in the types of companies now offering attractive dividends. Could you share some examples of companies or industries that are indicative of that change?

Jeff: Yes, I think you're right, Stewart. There has been a change in the dividend space. I think traditionally when you looked at the dividend space, people tended to think of it as a more defensive orientation. In the strategy, you don't get as much growth. You certainly don't have as much technology. Back in the ‘90s, early 2000s, there may have been this notion that if you're a tech company and you pay a dividend, then you don't have growth opportunities. You're lacking growth opportunities, right? Those days are gone. That's turned on its head. And if you look at some new dividend payers that have come to the market, Meta now pays a dividend, Alphabet now pays a dividend, Nvidia has for many years, Apple has, Microsoft does. You have 17 of the top 20 stocks in the S&P 500 that pay dividends. And in many cases, these stocks have sort of the trifecta that an investor would be looking for.

They're growing and generating strong earnings, they're buying back shares which can help keep a lid on some of their valuations, and they're returning cash to investors via dividends. So ignore them at your peril. And I think markets have shown us in recent years that particularly the growth characteristics of those companies is very attractive. And I think the other thing that's changed in the rate world, the dividend world, is a more normalized interest rate environment where we're now in a world where treasuries are yielding more than dividend yield coming out of the equity market. That used to be the norm, but for about 20 years now, QE era, maybe not quite 20, but I'm getting there, you had treasuries earning less than the equity yield, the dividend yield coming out of the market. So now we're shifting back to what I would consider to be a more normalized market.

And in that market, traditionally speaking, we tended to see lower overall total returns, but we tended to see the dividend yield component be a larger contributor to the overall total return of the market. In fact, if you go back all the way to the 1930s and kind of go decade by decade, the average contribution of the dividend yield to the market's return by the decade is about 60%. So getting that income reinvesting it has been important in the 2010s that wasn't, and so far in the first four years here, four or five years here in the 2020s it hasn't been, but we're back to that more normalized environment. We're coming off some very robust market returns. It's reasonable to expect that that dividend yield component will be a much more important contributor to overall returns.

Stewart: This might be a goofy question, but it's interesting the companies you mentioned that are paying a dividend, and this goes back to when the earth was cooling and I was running money, but there were investors who wouldn't buy a stock that didn't pay a dividend. Is that part of the reason that you're seeing these companies offer a dividend, even if it's a small one, just to kind of include that investor base in their potential investors?

Jeff: Yes, certainly. I presume that is part of the equation for these companies. Many of them are mature companies now, so they have the wherewithal to pay a dividend, grow the dividend. It can be an attractive characteristic from an investor perspective. These mega-cap stocks we mentioned, I mean, they have a tremendous amount of cash flow, and so they have the ability to reinvest that money in their business models to help 'em continue to grow, and buy back stock, and issue dividends–all high-quality attributes that an investor would seek.

Stewart: And so you kind of touched on this, these mega caps, right? And it seems like there's some discussion about market concentration, particularly in US equities. I know that you both are focused on global equities as well, but how concerns should insurers be about the current market concentration levels and how do you think about that at Northern Trust?

Michael: I'll take that one. So we are global investors. We invest across the acqui spectrum and well beyond. A couple of things I'll say about that. Number one is in the US we don't know what concentration actually looks like. You want to see a concentrated benchmark, go to Australia, go to New Zealand, go to Canada, go to the emerging markets. Those are concentrated benchmarks. So I think it's a little bit of a misnomer that we are experiencing this unusually high elevated level of concentration in the US. Now, that being said, I cannot deny that currently, about 10 stocks make up 37% ish of the total market cap of the S&P 500. So it's more concentrated than it has been in the past. There's no question about that. So what does that mean? That means two things. Number one is that your risk of a cap-weighted benchmark like the S&P 500 is much higher than it used to be.

The S&P is, I would say, no longer a well-diversified portfolio, so to speak, when you have 10 names making up 37% of the market cap. And those names are more or less all in the same business of internet retailing if you will. So you do have a concentration of risk in addition to a concentration of market cap that a lot of our clients are trying to deal with right now. So one of the ways of doing it is to go internationally and diversify outside the US, maybe less popular than it has been in the past, given European growth prospects. Another is to go down market cap into small caps, and that has become more popular over the last couple of years. But a great way of getting diversification is moving toward benchmarks that have a different profile than market cap spectrum. So, dividend benchmarks do in fact do that.

Now, if you're a dividend investor, one of the big challenges of concentration is that to Jeff's earlier point, if you want to overweight something, you have to underweight something. And, historically speaking, it has been an underweight to the growthiest names in the universe because they tend historically not to pay a dividend. This means that you have a lot of risk embedded potentially in your active decisions, and you have to be cognizant of that. One of the things that we do in our portfolios is have a maximum underweight of any security, even if it doesn't pay dividends. You need to control the idiosyncratic risk in your portfolio now more than ever, and nothing is a better example of that than dividend investing. So you really, really, really have to be cautious in a concentrated market about how you're sourcing your underweights because you could be introducing a lot of idiosyncratic risk into the picture.

Stewart: That's a really interesting point. I've never really thought about that. Thank you. That's an interesting perspective. We've seen strong returns in equities, particularly in the US markets. I guess, Michael, I'm going to go to you, but certainly Jeff, you're welcome here too. What are your thoughts on current market valuations and are there implications insurers should be considering when they are looking forward?

Michael: Obviously, the last few weeks we've seen some big changes in valuations, but let's say that the S&P right now is about 24 times earnings on the historical trailing PE ratio. If you're a property and casualty insurer and a third of your portfolio is in public equities. As I stated before, it's probably the biggest source of your overall portfolio risk. So you really, really need to be cognizant of what this implication is. Now, all that being said, two comments. Number one is that historical multiples are interesting, but forward multiples are far more interesting. And by and large, our expectation is that earnings will be quite robust even despite all the tariffs and the volatility that we've seen in markets lately, such that the forward multiple actually looks pretty attractive. It dipped below 18 for the S&P 500, and that's a two-year forward multiple.

So if earnings do play out in accordance with consensus expectations, a multiple of 18 is about what you would expect historically given a 10-year treasury yield of 425, 450 or so. So that piece of it is not so much of a concern, but even more so a reason to think about dividend investing. You might recall that dividend yield and value are strongly correlated with each other. In fact, you can use dividend yield as kind of a value signal, especially within the United States where companies tend to pay a relatively fixed dividend rather than a percentage of profits, which is true outside the US. So if you're worried about valuations, a higher dividend yield stance actually corrects for a lot of that. And Jeff, you can jump in here right now. What is the average PE of a dividend yielding strategy? It's going to be far less than the 23ish that you see on the S&P right now and the forward multiple because earnings expectations for a lot of these high dividend yield stocks are still quite good, are even better than the benchmark itself. So I think, again, dividend investing is a great avenue if you're concerned, but looking at those forward multiples, it's not the thing that keeps us up at night.

Stewart: Jeff, I'm going to give you a chance, or I don't want to put you on this spot, but do you happen to know that number off the top of your head?

Jeff: For the dividend cohort?

Stewart: The PE versus the S&P 500?

Jeff: Yeah, it kind of depends how you might slice it, but Mike SEPs are right. There's a value component to it. If you're looking at the very, very top of the dividend yield space, very high yielders, you might be looking at 14, 15 times forward earnings. A more broad look at it, you're probably looking at 15 to 17 times, so less expensive than the market overall. And that can give you a little bit of the protection that generally comes along in this space, a little bit of the defensiveness. Should we hit a rough patch, which we have here to start 2025, and in fact, dividend-paying stocks have done relatively well.

Michael: And they've done well because again, the earnings component has really held up. So there's something fundamental behind it that's very positive.

Stewart: There's not very many universal truths in insurance investing, but one of them is that insurance companies certainly appreciate downside protection, and that's because it has an impact on their capital. So your point's well taken there. So insurers have a variety of tools at their disposal from ETFs, mutual funds, separate accounts, customized approaches. Can you talk about the toolkit available to insurers and which vehicles might be most beneficial, and how Northern approaches constructing an equity strategy specifically suited to insurers?

Jeff: Yeah, thanks, sir. I can take that one. If you think about an insurer that wants to have broad participation with equity markets, you're looking for capital appreciation on that portfolio. Certainly, a relatively easy way to access that would be through an ETF or a mutual fund or some sort of beta strategy that can give a degree of convenience, some cost-effectiveness in that approach. And then if you expand that to say, as Mike was mentioning earlier, while I'm a taxable investor, so I need to consider after-tax returns as well, that starts to take you into a world of separately managed accounts with a tax manager, like Northern Trust. I know, Stewart, you mentioned the work our firm does, and you previously had the leader of that group on. Again, stepping further as insurers, you think, okay, that dividends received deduction, as you had mentioned. That's valuable as well from an after-tax perspective, where all else equal, if I can take my return, decompose it between capital gain and dividend income, I'd rather have the dividend income that's more tax advantaged with the dividends received deduction.

Again, all else equal. The trick is to try to equalize that so you can get that total return. We're talking about that. And then I think if you go further beyond beta solutions with a tax overlay on top, maybe an income solution, you think about other things that insurers would be attracted to, downside protection, as we just mentioned, that higher yielding strategy. Strategies that might offer some outperformance given the market conditions we're in. If we look at where we are today, you look at the equity risk premium, the stock market, which is the earnings yield, so that's the inverse of the P. So E over P minus a risk-free rate, say the 10-year, that's your equity risk premium. If you look at that today, it's negative. It hasn't been negative in a really long time. It's basically flat or negative and forward returns when that equity risk premium as compressed as it is today, tend to be relatively muted. But what tends to work well in that environment are factor strategies such as quality, low volatility, value dividends, all the sort of things we've been talking about. So from a solutions perspective, as you start to expand the opportunity set for insurers, yes, beta solutions are very convenient, cost-effective, and as you go further, you get into customization, you put in that tax overlay, and you can target these different factor exposures for some particular outcomes.

Stewart: That's super helpful. You guys have done a great job with giving us a really terrific education today on the equity markets and thinking about how to think about dividends and really how to craft a portfolio that is consistent with the objectives and constraints of an insurance company, which you both know very well. If you were going to just boil it down and have a couple of key takeaways for our audience from this podcast, what would they be?

Michael: Yeah, I think to Jeff's earlier point, just remember always that dividends account for a large portion of the total return of the equity market. Over the last few years, maybe not so much, but over the long term dividends matter. But also when you think about dividend strategies, design matters a lot, whether it is being relatively sector neutral, as we talked about, where we don't take big bets on sectors, we don't take big bets on stocks. The difference between strategies that do well and kind of blow themselves up in the process is extreme. So always be cognizant of how you think about designing that high dividend yield strategy.

Stewart: That's perfect. Thank you so much. So, couple of questions for you both out the door. The first one really is again, geared to folks who are younger in the business, and the question is about the characteristics that you look for when you're adding folks to your team. Not the skillset, not the major, the school, but the characteristics that you're looking for when you're talking with somebody. Who's the right fit at Northern Trust?

Jeff: Yeah, I think you're right, Stewart. I mean, there's no shortage of bright people that have credentials, and certainly, we see our fair share of candidates that are really, really impressive people. I think for me personally, one of the things I would look for is someone that has some of the softer skills, the ability to communicate, the ability to form relationships. I think that's still critical in our business, particularly as more and more of what we do becomes data-driven and analytically driven. Being able to not only understand and process that data and the analytics around that, whether it's artificial intelligence or machine learning, et cetera, but also being able to communicate that and explain that in a digestible way. I think that is a critical skill going forward, and that would be my advice to young people coming to us today.

Stewart: That's super helpful. Now, the last one's just pure fun. So, Mike and Jeff, you two are going to lunch or dinner and you each get to invite one guest alive or dead. Michael, you're a veteran of the show. Who would you most like to have lunch with? Alive or dead? And Jeff, you've got a minute to think. So that's a big advantage.

Michael: It's a great question. Off the top of my head, I'm going to give you a super geeky answer, but I'll explain how it's actually relevant. I mentioned earlier I'm a mathematician by training, and you see a lot of movies about Oppenheimer and John Nash and mathematicians, physicists. They have these great stories behind them. None of that compares to an individual, a Hungarian mathematician named John von Neumann. John Von Neumann contributed more to game theory economics, quantum mechanics, the Manhattan Project, than all of those other people combined. Not only that, but he had a tremendous influence on Harry Markowitz, George Danzig, who really created modern portfolio theory and optimization. So he is the person that has set this field off more than anybody else. So a mathematician, absolutely brilliant, doesn't get nearly enough press. John von Neumann is my answer.

Stewart: Wow, that's a good one. You know what? Here's the thing, on this podcast, super geeky wins, right? It does. We're nothing if not super geeky over here. Jeff, how about you? That's a tough act to follow, by the way.

Jeff: Yeah, that's a tough act to follow. I don't know if my guest can bring that acumen that yours can, but I think I'd have to answer that just personally. I would have my dad come. I lost my dad when I was just a teenager. So if you tell me I can have a meal with one person, even if Mike and his great guest will be joining us, I would be spending my time with my dad, share the things I've done, tell him about my family, his grandson. So yeah, that's an easy one for me.

Michael: That's an even better answer.

Stewart: That's touching, and I'm sure your dad is incredibly proud of everything that you've been able to accomplish, Jeff. So that would be a heck of a dinner. There would be some translating. If I was part of that deal, there would be some translating going on. I mean, I can tell you that would be very interesting. So thanks so much for being on. I really appreciate you both, and we look forward to having you back.

Michael: Always. Thank you.

Jeff: Thank you. Pleasure.

Stewart: Our pleasure. So we've been joined today by Michael Hunstad, deputy CIO and CIO of global equities, and Jeff Sampson, senior portfolio manager of global Equity at Northern Trust Asset Management. If you like us, please rate us and review us on Apple Podcasts, Spotify or Amazon, wherever you listen to your favorite shows. I do want to make mention that we have trademarked the term Home of the World's Smartest Money, and I'm very sincere about that with my insurance investment colleagues. I was having a very interesting conversation with John Patton while we were in Bermuda. I've never been more convinced of that. So kudos to all of you out there on the buy side of the insurance space. Big shout out to y’all, and I look forward to seeing you again soon on the InsuranceAUM.com podcast.