What do we learn from the above data? First, the high R-squareds, especially in the case of VIG, demonstrates that the returns of the two funds are well explained by their exposure to these well-documented common factors.
Second, some of the outperformance in down markets is explained by the fact that the market betas of the two funds are below 1—they have less exposure to market beta than the market does.
Third, the funds also have negative exposure to the size factor—their holdings are larger than those of the market. And large stocks tend to outperform riskier small stocks in bear markets.
Fourth, the two funds have large and highly statistically significant (t-stats of at least 4.2) exposures to the quality factor. Quality stocks are “defensive,” tending to outperform in down markets.
And finally, and perhaps most importantly, the two ETFs both have alphas of about -1%, far greater than their expense ratios. That means the funds were subtracting value, not adding value.
The evidence is consistent with economic theory—there is nothing special about dividends, with the returns of dividend-paying stocks well explained by exposure to common factors. Dividends are neither positive nor negative, at least from a pretax perspective. For taxable investors, dividends have negative implications relative to share repurchases.
In addition, a focus on dividends reduces diversification because about 60% of U.S. stocks and about 40% of international stocks don’t pay dividends. Thus, any screen that includes dividends results in portfolios that are far less diversified than they could be if dividends were not included in the portfolio design.
Less diversified portfolios are less efficient because they have a higher potential dispersion of returns without any compensation in the form of higher expected returns (assuming the exposure to common factors is the same). And finally, a focus on dividends often leads investors to focus on U.S. equities, creating a home country bias and a less diversified portfolio.
The bottom line is that dividend growth strategies are basically quality strategies. The good news about the quality factor is that the premium (about 4.7% a year from 1958 through 2018, according to data from AQR Capital Management) has been persistent and pervasive around the globe.
However, there are no generally accepted, logical, risk-based explanations for the quality premium because quality stocks are, by definition, safer investments. And safer investments should have lower returns. Thus, the quality premium is a behavioral anomaly.
And without a risk-based explanation, it’s possible that the premium could shrink or even disappear, especially since the premium has become well known since the publication of research such as the 2013 studies “Global Return Premiums on Earnings Quality, Value, and Size” and “Buffett’s Alpha.” The popularity of the strategy could cause the trade to be “crowded,” driving valuations higher and expected returns lower.
Ultimately, you are likely better served by focusing on investing in strategies that provide exposure to the factors you want to invest in. A focus on dividends, whether dividend growth or high-dividend yield, is not likely to add value.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.