The popularity of ETFs has naturally brought about significant evolution over time. Many of the earliest ETF products were built to track market cap weighted indexes. As time has passed, providers have introduced different index composition strategies including equal weighting, fundamental weighting, revenue weighting, and dividend weighting. While dividend investment strategies have existed for decades, the current environment of elevated US stock valuations and low interest rates has many people wondering if they should tilt their portfolio to a more dividend focused approach.
Results From the Data are Mixed
Academics have long researched the hypothesis that dividend paying stocks outperform their non-paying brethren. WisdomTree argues in their recent study, The Dividends of a Dividend Approach, that high dividend paying stocks outperform over time. Wharton professor Jeremy Siegel’s research divides S&P 500 dividend paying stocks into five quintiles and looks at their performance going back to 1957. The research shows the two quintiles with the highest dividends outperform the S&P 500 by over 2% per year, while the remaining three quintiles underperform by 0.8% – 1.3%. Based on this data, the answer seems simple: overweight the highest dividend payers.
Vanguard Research has come to a different conclusion using a different data set, however, which comes from global equity performance over the past twenty years. Their data divides stocks into four quartiles based on yield. The results show while the highest dividend quartile obviously pays out greater income, the total return between these stocks and the lowest yielding are virtually identical, certainly nowhere near the 2% annualized outperformance that Seigel found. Based on this data, Vanguard argues for a total return approach to investing where the dividend yield is a small, almost insignificant factor.
In addition to these two studies, below is a simple chart showing the performance differences between four ETFs since 2006: iShares Select Dividend (DVY), Vanguard Dividend Appreciation (VIG), Vanguard High Dividend (VYM), and iShares Core S&P 500 (IVV):
Here are the total returns since 11/16/06:
VIG – 119%
DVY – 94.39%
VYM – 117.66%
IVV – 120.35%
As you can see from the data, the S&P 500 has marginally outperformed 3 popular dividend ETFs over the last decade. Of course, this is nowhere near the complete data set of high dividend paying ETFs. Also, the next five, ten, or fifty years could look completely different. Perhaps dividend strategies could outperform going forward. But as of now, the data regarding dividend strategies seems mixed and inconclusive.
Other Factors to Consider
Part of the reason it’s challenging to make a black and white determination on dividend strategies is because it’s difficult to isolate dividends as the only variable in the equation. Companies that pay high or growing dividends are often more mature, have a more stable financial condition, and have lower growth rates than companies that do not. This means in many cases, comparing a dividend payer to a non-dividend payer can be like comparing apples to oranges.
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Companies such as General Electric (GE) or Proctor & Gamble (PG), which are high dividend payers, have many other differences to a company such as Netflix (NFLX), which is a non-payer. So, it’s difficult to isolate the difference in the performance of these stocks which is attributable to the dividend payout and the difference attributable to a myriad of other factors. These companies have vastly different business models, dynamics, management teams, competition, valuations, and growth rates. All these factors affect their long run stock performance.
Conclusion
While the evidence on dividend strategies is inconclusive, it’s also possible that these strategies may make sense in certain situations. Investors wishing to implement a dividend strategy should consider the following factors when building their portfolio:
- Costs – Don’t overpay for a dividend ETF. There are many low-cost options available.
- Asset Allocation – Dividend paying stocks are not a substitute for bonds in a diversified portfolio. The risk profile of a dividend paying stock is still significantly different (riskier) than high quality fixed income.
- Sector Overweighting – Be aware of how tilting your portfolio towards dividends may affect your sector exposure. The higher your dividend tilt, the more likely you are sector overweighting without knowing it. Many dividend ETFs also have a significant tilt to value stocks and an underweight to growth.
- Taxes – Higher income means higher taxes for dividends received in a taxable account. Investors may consider positioning dividend strategies in tax deferred accounts such as an IRA.
The future performance of dividend strategies is unclear. Considering costs, asset allocation, sector allocation, and taxes when buying a dividend ETF can give you the best chance for future success.
This article was written by Ryan Gilmer, CFA, who is Vice President – Investment Management at TOPS ETF Portfolios, a participant in the ETF Strategist Channel.
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This article provides commentary on current economic and market conditions and is not directly relevant to any particular client account. The information contained herein should not be construed as personalized investment advice or recommendations to buy or sell any security. There can be no assurance that the views and opinions expressed in this article will come to pass. Investing involves the risk of loss, including the loss of principal.
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Source: Bloomberg for historic price and return references.
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