June 5, 2012
Assets are flowing into dividend-stock funds, as income-seeking investors look for alternatives to the low yields in the fixed-income markets. But many experts are warning that those investors are setting themselves up for significant losses. Using an objective methodology that assesses tradeoff between yield and risk, we can determine those funds that investors should prefer – and a few they should avoid.
One crucial thing about dividend-focused investing is that it is driven in large part by aging baby boomers, whose goal it is to construct de-accumulation portfolios with predictable income and low volatility. In addition, market volatility in recent years has made steady dividend payments especially attractive.
Those experts who caution against dividend funds warn that older investors are replacing low-yield bonds in their portfolios with riskier dividend stocks, inadvertently increasing portfolio risk at a point in their lives when they should be doing the opposite.
I will start by examining the key arguments in favor of dividend-oriented investing. I then explore the major classes of dividend-generating ETFs and mutual funds and compare them using a methodology that compares risk to yield, ultimately determining whether the higher yields that they offer justify the risks.
Elements of dividend investing
Dividends have historically made up a substantial portion of the total returns from equities. A recent article by Richard Skaggs, chief equity analyst at Loomis Sayles, provided updated statistics. Over the past 30 years, for example, dividends have provided 45% of the total return from the S&P 500.
While many advisors focus on total return, my research shows that six factors justify favoring dividend-paying stocks:
- Better estimation of risk for returns
- More rapid verification of return and yield estimates
- Higher quality of earnings
- Better alignment of incentives between corporate executives and shareholders
- Simplicity for retirement investors
- Increased attractiveness if the New Normal plays out
To estimate the future returns from any investment, one of the important sources of uncertainty is estimation risk. This is the risk that comes from our limited ability to estimate expected returns. Given that future returns are connected to future earnings, the research that shows that dividend-paying stocks have higher-quality earnings indicates there is less estimation risk associated with dividend-paying stocks than non-dividend payers.
A related advantage to dividend investing is what I refer to as verifiability. If I create a stock portfolio with an expected annual average return of 8% per year, I may have to wait for a very long time before I can confirm that my expected return figure was correct. If the portfolio –loses 8% in the first year, market volatility is likely to blame – but it will take several years to tell. Dividend-paying stocks sidestep this problem by providing returns via income that are verifiable quarter-by-quarter. If I hold a dividend-paying portfolio that does not provide its estimated 6% yield, there is clearly something wrong with my expectation.
Managers at firms that pay dividends have financial incentives more aligned with the interests of investors than those of executives at other companies. Management will focus on maintaining dividends, whereas at non-dividend paying companies, managers are more likely to hold substantial stock option grants. Because they are judged on the basis of price appreciation, and because their stock grants give them an incentive to focus on short-term price gains rather than long-term earnings quality, these managers are more likely to take risks.
It also helps that dividend-paying stocks are a key component of income portfolios, which are gaining popularity in de-accumulation strategies. Many retirees want to consume only the dividends or other sources of income generated by their portfolios, in order to reduce the risks of totally depleting their portfolios.
Finally, dividends will be attractive if the New Normal worldview described by Bill Gross and Mohammed El-Erian plays out. This outlook suggests economic growth will slow in the developing world, and that asset returns will be more modest that their historical norms. Accordingly, investors will favor dividends and drive up the prices of those stocks.
The major problem for dividend investors, however, is that dividend yields rise when companies are in distress. Facing adverse conditions that cause its stock price to fall, a company will be reluctant to cut its dividend, fearing the negative signal to investors. With a constant dividend payment and a falling stock price, yield rises. Very high yields can be a sign of distress and warn of an impending dividend cut; this is the so-called value trap.
Against this backdrop, let’s explore the mutual funds and ETFs that focus on dividend stocks.
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