Swedroe: Dividend Strategies Fall Short

As I have discussed in the past, the Federal Reserve’s easy monetary policy aimed at driving down interest rates, and keeping them at historically low levels, has led many investors, in a search for income (cash flow), to pursue dividend strategies (either high dividend and/or dividend growth).

While the first dividend ETF wasn’t issued until August 2003—shortly after the Jobs and Growth Tax Relief Reconciliation Act passed in May 2003, which lowered the top individual tax rate from 38.6% to 15% on dividends, ensuring dividends and capital gains would be taxed at the same level—by the end of 2014, there were 28 dividend-oriented ETFs with more than $80 billion in assets. Since then, interest in these funds has continued to grow.

Measuring Dividends’ Benefits

Given that economic theory states dividend policy should be irrelevant to stock returns, an important question is: Have investors actually benefited from their focus on dividends rather than total return?

Srinidhi Kanuri, Davinder Malhotra and Robert McLeod, authors of the study “Performance of Dividend Exchange-Traded Funds During Bull and Bear Markets,” which was published in the Summer 2017 issue of The Journal of Index Investing, sought to examine the performance of ETFs that employ a dividend strategy.

Their data sample covered the period 2004 through 2014. Following is a summary of their findings:

• The equal-weighted monthly average return of the dividend ETFs examined in the study was 0.74%, almost identical to (though slightly higher than) the 0.72% monthly return of the iShares S&P 500 ETF (IVV).
• The equal-weighted average monthly standard deviation of divided ETFs was also almost identical, at 4.09%, to that of IVV, which was 4.08%.
• The equal-weighted dividend ETFs marginally outperformed IVV, both on an absolute and risk-adjusted basis, during the bull market of January 2004 through September 2007 (average monthly return of 0.89% versus 0.87%), and during the bull market of April 2009 through December 2014 (average monthly return of 1.71% versus 1.63%), while producing higher risk-adjusted returns.
• Perhaps surprisingly, dividend ETFs outperformed during periods of rising interest rates, but underperformed during the period of falling rates.
• The equal-weighted dividend ETFs underperformed IVV on an absolute basis, while also experiencing greater volatility, during the bear market of October 2007 through March 2009 (with an average monthly return of -3.37% for the dividend ETFs versus -3.15% for IVV). Their performance was hindered by their higher expense ratios and the fact that companies cut dividends during this period.

The bottom line is that Kanuri, Malhotra and McLeod didn’t find much difference in performance between the S&P 500 and the dividend strategy ETFs.

But because dividend ETFs are not restricted to stocks within the S&P 500 Index, and investors have broader opportunities, let’s extend the authors’ analysis to a comparison with the wider Russell 3000 Index.

Further Comparison

From 2004 through 2014, the SPDR Russell 3000 ETF (THRK) provided a monthly average return of 0.76%, outperforming the S&P 500 ETF’s monthly average return of 0.72%, as well as the 0.74% monthly return of the equal-weighted dividend ETF portfolio. The slight advantage that dividend strategies offered relative to the S&P 500 Index disappeared completely when the broader market index is considered.

Note that while THRK provided a slightly higher monthly return, it did so with the slightly higher volatility of a 4.24 monthly standard deviation versus a standard deviation of 4.09 for the equal-weighted ETF portfolio.

In short, the historical data supports the theory that there’s nothing special about dividend strategies. And interestingly enough, they performed worse during the 2008-2009 financial crisis, when investors were likely expecting them to perform better.

Summarizing, the returns to dividend strategies are well-explained by their exposure to common factors (such as market beta, size, value, momentum and quality). In addition, at least for taxable investors, dividend strategies are generally less efficient than total return approaches.

Finally, dividend strategies result in less diversified, and thus less efficient, portfolios because today about 60% of U.S. stocks and about 40% of international stocks don’t pay dividends, which begs the question: Why are they so popular?

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.