Q: What is the history of the fund?

The fund began in 1999, under the name SunAmerica Dogs of Wall Street. In 2002, it was renamed SunAmerica Focused Dividend Strategy Portfolio and, four years later, the underlying investment process and portfolio construction were altered. 

Until 2006, the fund was a 30-stock portfolio consisting of the 10 “Dogs of the Dow,” the highest yielding stocks in the Dow Jones Industrial Average. The remaining 20 stocks in those early years were the 20 highest-yielding stocks in the S&P 500 Index. 

In 2006, after extensive quantitative analysis and back-testing, we replaced the 20 S&P 500 high-yield stocks with a new, more dynamic model, which we call the “enhancement,” where we began culling those 20 stocks from the Russell 1000 Value Index instead.

The portfolio today is the same as it was when we instituted the 2006 enhancement: the 10 Dogs of the Dow, and 20 of the Russell 1000 Value Index’s highest-yielding stocks, determined by our rules-based metrics—yield, profitability, and valuation. 

In terms of assets under management, there exists roughly $9.3 billion across the fund’s share classes. This focused dividend strategy fund is SunAmerica’s flagship product, and the main product of our rules-based investment process. 

Q: How does your fund differ from other funds?

We apply a rigidly disciplined, rules-based process. The portfolio stock selection, portfolio construction, and trading are all governed by a strict set of rules from which we never deviate. There is no fundamental analysis or overlay. Some rules-based or quantitative funds have a research overlay where the research ranking might play a part in stock selection. We don’t do that. 

We let the models, either the Dogs of the Dow or the enhancement model, drive our stock selection. That is something that separates us distinctly from our peers, many of which are more qualitatively fundamentally oriented than our process. 

Q: What core beliefs propel your investment process?

We believe in low turnover. We run our rules-based model at the end of every October and, at that time, reconstitute the fund accordingly. On average, about one-third of the portfolio changes each year—it has ranged from eight to 15 of the 30 names. That’s relatively low. 

We also only trade the fund once a year, in its entirety. We rebalance the positions, doing all the buys and sells in one large batch trade, which dramatically lowers our trading and commission costs, relative to our peers. 

The fund is always a 30-stock portfolio—we never deviate from that. We believe that adhering strict discipline to a rules-based process is a winning formula in today’s marketplace. We have a rule for everything that might occur in the Focused Dividend Strategy Portfolio. 

Q: What is your investment strategy?

In addition to the 10 Dogs of the Dow portion of the portfolio, the other part of our process and strategy is a rules-based model, which excludes financials and utilities, and screens the Russell 1000 Value Index for yield, profitability, and valuation. 

The yield metric is anything equal to or above the median of the S&P 500’s dividend-paying securities, currently 2.09%. 

The other metrics are more proprietary in nature. Generally speaking, the profitability metric is a high return on capital. And we screen for low valuations on cash flow. 

Those three metrics are equally weighted in our screening process. From there, we take the top 20 ranked stocks from that screen and combine them with the 10 Dogs of the Dow to create our 30-stock portfolio.

There’s no portfolio management bias in that respect, and no research analyst overlay. It is strictly a rules-based strategy, which, as I said, is uncommon in the marketplace. There are other funds that are focused, other large-cap value funds that perform quite well and have high dividend yields, but we have yet to find another fund that is focused and as disciplined in its rules-based process as ours is.

Q: What constitutes the “Dogs of the Dow” strategy?

It’s a well-known strategy. The moniker is a bit misleading, particularly from a marketing standpoint, because the Dogs of the Dow are the Dow Jones Industrial Average’s highest-yielding stocks. Those top ten stocks can give us a premium yield. 

All 10 are mega-cap companies, all high-quality U.S. companies, which can afford us downside protection. These 10 Dogs of the Dow tend to act as a governor in the portfolio during what we refer to as drafty markets. Whether it be a significant downturn—such as we experienced in 2008, or less significant downturns but no less downwardly-biased markets, like we saw in 2010 and 2012—with 5% to 10% corrections in the market.

The Dogs of the Dow have performed well in those environments, so they are part of our risk mitigation process. That’s why we left them in there from inception and following the 2006 enhancement. 

In three of the last five years, the Dogs of the Dow have outperformed the S&P 500. Compare that with the previous seven years, when they significantly outperformed the S&P 500 only twice. These are quality companies that provide us yield, downside protection, and more recently, they’ve been performing well in all markets. But of course, past performance does not guarantee future results.

Q: What are the advantages of rule-based investing?

In the industry, we hear repeatedly that active management has underperformed, and there are a lot of reasons for that. When you compare our philosophy to those of the broader investing community, the tenets of our process, discipline, and low turnover, have historically served our shareholders well.

We are talking about systematic rules, focused portfolio, and limited trading, which are not unknown concepts in the investing world. They sound simplistic but are difficult to follow on a regular basis. When the market is selling off and you have a position that’s down significantly, it’s very hard to resist selling the position. 

Our rule-based process takes the emotion out of such decisions. A lot of investors, both retail and institutional, end up selling low and buying high. Adhering strictly to our rules means we avoid doing that. 

This discipline permits us to see how this decision impacts our investment returns in various market developments. We are not going to win every day, every month, or even every year, but we’re playing a long-term game. Our goal is to find good value stocks that outperform the market over time. 

In terms of turnover, longer holding periods generally tend to correlate with higher returns. Yet, the market has seen holding periods decrease dramatically. Once measured in years, holding periods are now often measured in minutes. 

With our annual reconstitution, we have very low turnover. Our average holding period is two to three years, which is longer than the broader investing community. We think that this is another way to potentially achieve higher returns relative to the market. 

Q: How do you create your rules?

We have a robust quantitative analysis function within the investment department. Our rules were derived from extensive quantitative analysis before being implemented. We test the metrics and, after back-testing, we go with what we believe to be an appropriate mix of metrics and rules. 

Q: How do you tackle portfolio construction?

Our benchmarks are the S&P 500 and the Russell 1000 Value Indexes, respectively, both large-cap portfolios. That’s where our stocks and our performance come from. 

On or about every first of November, we rebalance to our target weight, which is 3.3%. New names coming into the portfolio come in at 3.3%, and everything that is to remain in the portfolio is rebalanced to 3.3%. A name that has appreciated to, say, a 4% position, we trim back to our target of 3.3%. Conversely, if something has underperformed over the course of the year, we move the position back up to 3.3%. That is the only time of year we rebalance to target. 

In terms of diversification, we do not employ a quantitative optimizer. We do not have caps or limits on sector weights or diversification. Technology has been a significant overweight in the portfolio. 

We let the model dictate portfolio construction, often resulting in significant stock-specific selection or overweights in various market sectors. 

We believe that diversification benefits start to decline in portfolios greater than 30 to 40 names. We think a 30-stock portfolio is optimal for portfolio diversification. 

Accordingly, our portfolio has definition. It has higher tracking error than some, but not excessively. In terms of active share, which is a more recent characteristic that quantifies the differences in the concentration of holdings between a fund and its benchmark index, our portfolio has consistently been north of 80%. The greater the difference in concentration, the higher the active share and the more potential the fund has to generate alpha, or the amount a fund outperforms or underperforms its benchmark index. For instance, a fund with an active share of 0% has a portfolio that exactly matches its benchmark, while an active share of 100% means that the fund and benchmark have no overlapping holdings. In practice, an active share of 60% or higher is considered a “truly active” portfolio, while over 80% is highly active. Currently, active share for our portfolio is approximately 85%, which suggests it clearly differs from its benchmark, far from a closet index strategy. 

Q: What is your sell discipline?

In addition to our annual reconstitution, we have a yield hurdle rule. We check each position in the portfolio every month to determine its yield. If the yield has fallen below our yield hurdle, defined as the median of the dividend-paying securities of the S&P 500, which is currently 2.09%, we sell the position and replace it with the next highest-ranking stock.

So, our yield hurdle is a sell discipline. It happens infrequently, only seven times since 2006. Six out of those seven were cases where the stock’s price went up and the yield went down. Once it violated our yield hurdle, we sold it. Those were typically situations where a company got taken over or a takeover deal occurred and the stock rose significantly. 

The second rule is in the case of a takeover or corporate action, as we saw recently with one of our positions in the tobacco sector. Again, we ran the model and replaced that name with the next highest-ranking stock. No matter what, we always have 30 stocks.

Q: How does the process of bringing in new stocks work?

Our annual reconstitution begins in late October, where we use our single, rather complex model to determine the current 10 highest yielding stocks in the Dow Jones industrial Average and the 20 highest from the Russell 1000 Value, using our yield/profitability/valuation metrics.

We then send that 30-stock portfolio to trading around November 1st, because our fiscal year ends October 31st. By doing these trades on or about November 1st, we can better manage our tax situation.

In some cases we might do trades in October, perhaps if there’s a loss position, so we can reduce our capital gain. In other cases, such as a position with a short-term gain, we defer trading until it goes long term. It is very rare for us to book a short-term gain. 

We do look at some of the issues with respect to the changing Russell, but it’s rare that a name comes out of the Russell that would affect a name in our portfolio. More often, names move from growth to value, or from value to growth; this does not impact the portfolio. 

Q: How do you define risk and how do you control it?

We have a portfolio policy committee consisting of the Chief Investment Officer, analysts, and a few portfolio managers, including me. The committee meets at least twice a year for each portfolio and then as needed. We run extensive analytics on performance to establish where performance is coming from in terms of individual stocks and sectors and weightings. 

We also look at risk over time. Speaking generally, we look at stock selection, factor tilt, data, valuation, etc., to identify not just where our performance is coming from, but also where most of our risk is concentrated. We analyze the portfolio characteristics—valuation, growth, and profitability are all metrics in our selection of individual holdings, but we want to analyze, too, how the portfolio looks relative to the benchmark. 

Other things we do are to break down the portfolio by things like market cap and P/E ratio. We look at the percentage of the portfolio that’s at a very high P/E bucket relative to the benchmark to determine where our risk lies. 

We also perform a returns-based analysis, relative to peers and relative to the index, to see what kind of valuation tilt we have, what kind of style box we end up in, and how our various risk characteristics compare to peers. So, we look at things like Sharpe ratio and track it over time.

Q: Are there other ways you tackle risk?

Our investment process is consistent; we don’t change it over time. In terms of the portfolio and the creation of the model, a lot of risk analysis was applied to the methods we employ: the relationship between the enhancement and the Dogs of the Dow. There is an ongoing assessment of risk, but the model was designed with risk in mind. 

The factors, the metrics—yield, profitability, and valuation—we didn’t invent them, but they do complement one another in terms of stock selection, performance, and risk. If we were to use just yield and valuation, we would probably have a deep value type of portfolio. Ours is not a deep value strategy. We like what the profitability metric does in the model, because it has tended to lift the quality of the name and stock selection, thereby offsetting some of the risk characteristics one might get from a deep value. 

We think our three chosen metrics complement one another well. 

The Dogs of the Dow is an important component of our risk mitigation strategy. As they are the highest yielding names in the portfolio, we get a premium yield. The yield of the portfolio is 2.5%, while the yield on the Dogs is 3.6%. Along with getting a premium yield, the Dogs of the Dow, being among the largest mega cap names in the U.S. marketplace today, help mitigate risk for us. They are one of the reasons why our downside capture has been low.

Our process has not changed since 2006. We managed to outperform the benchmarks on the way down during the financial crisis and on the way up in 2009, when the market rallied. We believe that these metrics can work well, no matter what the market conditions are. Again, past performance does not guarantee future results. 

Part of the challenge in marketing this fund is that, in the ’90s, the Dogs of the Dow were not great companies. Today, however, the Dogs of the Dow are great American companies that are not merely high yielding because their prices are down. They are high yield because many corporate CFOs know that the key to a premium multiple on your stock is a very balanced capital plan that includes a healthy dividend growth program and a dividend strategy. 

Dividends are an important part of investing, and have been for a long time. However, our strategy extends beyond dividends. Otherwise, we would have a lot of utilities and financials. We specifically avoid those areas of the market. 

Quality works over the long term in many market cycles. That’s what we’re after—what we have achieved historically in the Focused Dividend Strategy Fund. We identify high-quality attractive companies. We believe that combination is what may lead to outperformance over time.