Swedroe: Dividends An Illogical Preference

November 06, 2015

High Turnover’s Impact

As one example of the impact of high turnover, we can examine the performance of the aforementioned First Trust Dividend and Income Fund (FAV). Morningstar reports that for the five-year period ending Oct. 8, 2015, the fund provided a return of 6.8 percent per year.

During the same period, Vanguard’s 500 Index Fund (VFINX) returned 13.8 percent. Since Morningstar classifies FAV as a large value fund, we will compare it with other passively managed large value funds. The Vanguard Value Index Fund (VIVAX) returned 12.8 percent per year and the Dimensional Fund Advisors (DFA) Large Cap Value Fund (DFLVX) returned 14.5 percent per year. (In the interest of full disclosure, my firm, Buckingham, uses DFA funds in constructing client portfolios.)

Using the regression tool available at Portfolio Visualizer, we can analyze the impact of the high-dividend strategy. For the period October 2007 through August 2015—the longest period for which the data is available—FAV produced an annual alpha of -5.6 percent. The focus on high dividends was an expensive proposition.

Despite the many issues with juicing, the authors found that funds with an excess dividend ratio greater than 1.38 received, on average, an additional 6.8 percent of inflows a year compared with other funds with similar observable characteristics. An excess dividend ratio greater than 2 is associated with an additional 12.2 percent of inflows a year.

Identifying The Buyers

Furthermore, the authors sought to identify the buyers of funds that engaged in this bad behavior. The hypothesis would be that juicing must appeal to less sophisticated, uninformed investors. And consistent with this expectation, juicing is significantly less likely for funds with an institutional share class (institutions are considered to be more informed).

In addition, dividends should be more valuable to investors with lower income tax rates, or to those who pay no income tax at all. Yet juicing is more likely to occur among retail funds, whose investors have a greater likelihood of paying income tax on dividends when compared with institutional funds (which are more likely to have tax-free investors such as retirement accounts or charitable institutions).

Not surprisingly, given the less sophisticated nature of their buyers, the authors also found that juicing is more common for funds with higher expenses (which further serve as a drag on returns).

Finally, the authors noted their results are consistent with investors who psychologically distinguish between consuming income produced by their assets and consuming the capital value of their assets. This is simply a labeling error (or framing problem) and thus leads to irrational behavior. Unscrupulous mutual funds, however, cater—or pander—to the unsophisticated investor, charging higher fees and delivering lower returns with less tax efficiency.

To prevent such behavior, or at least to expose it and thus perhaps minimize it, the authors recommended that the SEC require funds to report their excess dividend ratios. I couldn’t agree more.

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

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