Swedroe: Beware Hot High-Dividend ETFs

A crowded trade such as into high-dividend funds can fail to deliver on its promise.

The low-interest-rate environment we've been experiencing for six years now has led to the increased popularity of high-dividend investment strategies. But the popularity of a strategy, however, can sow the seeds of poor future returns.

This occurs because cash flows impact valuations, and valuations are the best predictor of future returns. Given the growing popularity of high-dividend strategies, and the increased cash flows associated with that growth, I thought it worthwhile to do some research into how relative valuations have changed over time.

To begin, prior research has shown that a high-dividend strategy is really just a poor man's value strategy. A value premium exists whether you rank stocks by P/B (price-to-book), P/S (price-to-sale), P/CF (price-to-cash flow), P/E (price-to-earnings) or D/P (dividends-to-price). The lowest premium has been to D/P, or dividend yield. With that in mind, let's examine what has happened to the relative valuations of stocks in a high-dividend strategy.

For our analysis, we'll consider the top quintile of stocks, ranked by dividends, and use that as our high-dividend strategy. We'll then compare the BtM (book-to-market) ratio of that strategy with the BtM of the first decile of CRSP stocks (CRSP 1). We'll use month-end data for the period from January 1971 to April 2014.

The average BtM of the high-dividend strategy was 0.76, compared with an average BtM of just 0.58 for the CRSP 1. From a BtM perspective, the high-dividend strategy was trading 31 percent more cheaply than the CRSP 1.

This is important because the research shows that the wider (or narrower) the BtM spread between growth and value stocks, the larger (or smaller) the value premium. At the end of April 2014, the BtM of the high-dividend strategy was 0.43. The BtM of the CRSP 1 was 0.47. The high-dividend stocks were now trading about 9 percent more expensively than the CRSP 1. They no longer looked like value stocks.

We see similar results when we compare the valuation metrics of the SPDR S&P 500 Dividend ETF (SDY | A-69) to the metrics of the iShares Russell 1000 ETF (IWB | A-92), which is a market-oriented fund, and the iShares Russell 1000 Value ETF (IWD | A-85). The table below is based on Morningstar data as of July 3, 2014.

We should certainly expect that a high-dividend strategy would have a higher D/P ratio than a market-oriented fund like IWB, and that's what we find. However, what's both surprising and troubling is that the other three valuation metrics show that IWB is now more "valuey" than SDY.

We also see that these three valuation metrics for IWD are dramatically lower than they are for SDY. The higher valuations of SDY forecast lower returns, yet the dividend yields are virtually identical.

The bottom line is that the popularity of high-dividend strategies has driven their valuations to levels that are no longer value-oriented. This changes the nature of the fund in terms of what investors should expect in returns. Unfortunately, it's almost a certainty that most investors are unaware of this impact. You now no longer have this excuse.

If or when interest rates rise to levels that provide more competition for the yields on high-dividend stocks, investors who moved assets from safe bonds into a high-dividend strategy may try to exit at the same time.

This is crucial to note because the correlation of Treasury bond yields to the relative valuation of high-dividend payers has been about 80 percent since 1986. When yields go down, dividend payers get more expensive and vice versa. You never want to be the owner of investments in "crowded trades."

The exits, when they happen, can get ugly.

Larry Swedroe is the director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.