Swedroe: The Dividend-ETF Trap

Dividend-paying stocks may be hot, but valuations are key.

Over the last few years we’ve seen a dramatic increase in interest in dividend-paying stocks. The heightened interest has been fueled by both the media hype and the current regime of interest rates that are well below historical averages.

The low yields available on safe bonds led even many once-conservative investors to shift their allocations from safe bonds to dividend-paying stocks. This is especially true for those who take an income, or cash flow, approach to investing—as opposed to a total return approach, which I believe is the right one.

One thing that I would assume that all investors agree on is that valuations matter. And the academic research demonstrates that the best predictors (have the highest explanatory power) of future returns are value metrics such as price-to-earnings (P/E) ratios. The higher the relative price, the lower future expected returns.

We also know that other “value” metrics also produce similar rankings. It doesn’t matter whether we look at price-to-cash flow or price-to-book, the higher the relative prices the lower the future expected returns.

The table below shows the value metrics of P/E, P/B, and P/CF for two of the most popular dividend strategies, the SPDR S&P Dividend ETF (SDY | A-73), with almost $12 billion in assets under management, and Vanguard’s Dividend Appreciation ETF (VIG | A-70), with over $18 billion in assets. VIG buys the stocks of companies with rapid growth of dividends.

It also shows the two large-cap value ETFs with the most assets under management, the iShares Russell 1000 Value ETF (IWD | A-85) and Vanguard’s Value ETF (VTV | A-97).

As you review the data, remember that the lower the relative price, the higher the expected return. (The data for SDY and IWD is as of Feb. 14, 2014 and as of Jan. 31, 2014 for VIG and VTV, most current data available. All data comes from Morningstar.)

The above data makes clear that popularity of the two dividend strategies has led to a rise in the prices of these stocks and reduced the expected returns. No matter which value metric we look at, the expected returns for both SDY and VIG are now well below the expected returns of the two large value strategies.

As you consider the data, also keep in mind that for taxable investors, dividends are less tax efficient than capital gains. They cause you to pay taxes sooner, they can drive you into higher tax brackets, and they also lose the potential for stepped up basis upon death that’s present with capital gains. Also, in tax advantaged accounts you lose the benefit of the foreign tax credit.

The bottom line is that you shouldn’t get caught up in the hype of dividend-related strategies. If you have gotten caught up in that hype, or believed in the “conventional wisdom”, perhaps the evidence will lead you to conclude that there’s a better way.

Be careful out there, and remember that “this time is different” are perhaps the four most dangerous words when it comes to investing.

Larry Swedroe is director of Research for the BAM Alliance, which is part of St. Louis-based Buckingham Asset Management.