Swedroe: Vanguard Debunks Dividend Myth

Dividend strategies have drawn increasing interest from investors around the world as central banks have pursued both quantitative and qualitative easy monetary policies, keeping interest rates at what have been exceptionally low levels since 2008.

But this preference isn’t entirely new; it has long been known many investors have a preference for cash dividends. From the perspective of classical financial theory, this behavior is an anomaly.

It’s an anomaly because dividend policy should be irrelevant to stock returns, as Merton Miller and Franco Modigliani famously established in their 1961 paper “Dividend Policy, Growth, and the Valuation of Shares.”

As they explained it, at least before frictions like trading costs and taxes, investors should be indifferent to $1 in the form of a dividend (causing the stock’s price to drop by $1) or $1 received by selling shares. This must be true, unless you believe that $1 is not worth $1. This theorem has not been challenged since—except by those bitten by the “dividend bug.”

Moreover, the historical evidence supports this theory—stocks with the same exposure to common factors (such as size, value, momentum and profitability/quality) have the same returns whether they pay a dividend or not. Yet many investors ignore this information and express a preference for dividend-paying stocks.

One frequently expressed explanation for this preference is that dividends offer a safe hedge against the large fluctuations in price that stocks experience. But this ignores the fact that when a dividend is paid, the stock’s value is offset by an equal fall in the stock’s price. It’s what can be called the fallacy of the free dividend—the only free lunch in investing is diversification, not dividends.

What’s particularly puzzling about the preference for dividends is that taxable investors should favor the self-dividend (by selling shares) if cash flow is required. Unlike with dividends—where taxes are paid on the distribution amount—when shares are sold, taxes are due only on the portion of the sale representing a gain. And specific lots can be designated to minimize taxes.

Evidence Supports Theory

Todd Schlanger and Savas Kesidis from Vanguard’s research team contribute to the literature on dividends through their May 2017 study, “An Analysis of Dividend-Oriented Equity Strategies.”

They examined the similarities and differences between two popular dividend strategies—high-dividend-yielding and dividend growth. They also considered the implications of using these strategies in the context of portfolio construction relative to both high-quality fixed income and equities.

Note that dividend growth equities tend to yield less than global, broad-market equities. However, proponents of this investing style believe a record of continuous dividend payments serves as an important indicator of a company’s quality.

Following is a summary of the authors’ findings:

• Across quartiles, income and capital returns showed little relationship, with, paradoxically, the highest-yielding and lowest-yielding quartiles showing the closest total returns.
• Absent beneficial tax treatment (as previously noted, in the U.S. there are negative tax impacts associated with dividends), dividend-oriented equity strategies are best viewed from a total-return perspective, taking into account returns stemming from both income and capital appreciation.
• Substituting dividend-oriented equities for fixed income significantly raises a portfolio’s risk profile and diminishes its downside protection due to the loss of the diversification benefits provided by high-quality bonds.
• Dividend-oriented equities tend to have greater interest rate sensitivity than other equities, making their performance more exposed to term risk and increasing their correlation with bond returns. Dividend-oriented equities tend to experience greater price declines when interest rates rise, and greater price increases when rates fall.
• Compared with other equities, the performance of these strategies has been time-period dependent. For example, they outperformed during the technology stock bear market of 1999-2000, but underperformed during the 2008-2009 global financial crisis.
• As theory predicts, the performance of dividend strategies is explained to a large degree by exposure to a handful of equity factors: value and lower volatility for high-dividend-yielding equities, lower volatility and quality for dividend growth equities. Additionally, multifactor regressions showed very high explanatory power, 0.95 for high-dividend strategies and 0.89 for dividend growth strategies. Thus, we can conclude that the historical performance of these strategies can be largely explained by exposure to common factors.

Vanguard’s conclusion that a total-return approach is superior to one that focuses on dividend strategies is interesting in light of the fact that they offer dividend strategy funds: the Vanguard Dividend Appreciation ETF (VIG) and its mutual fund counterpart, the Vanguard Dividend Appreciation Index Fund (VDADX), as well as the actively managed Vanguard Dividend Growth Fund (VDIGX).

Focus On Dividends Reduces Diversification Benefits

It’s important to understand that a preference for dividends has negative implications in terms of diversification, because about 60% of domestic stocks and about 40% of international stocks don’t pay dividends.

Thus, any screen to include only dividend stocks results in portfolios that are much less diversified than they would be if nondividend payers weren’t excluded 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 forward-looking return expectations (assuming the exposure to investment factors are the same).

Before concluding, there is one more important point to cover. As previously noted, both the high-dividend-yielding and the dividend growth strategies have exposure to the low-volatility factor, which has been “cursed by popularity” as low-volatility strategies experienced large inflows in the aftermath of the 2008-2009 financial crisis.

To see the impact of this heightened popularity, we’ll take a look at the valuation metrics of the two largest low-volatility ETFs, the iShares Edge MSCI Min Vol USA ETF (USMV), with $13.8 billion in AUM at the beginning of September 2017, and the PowerShares S&P 500 Low Volatility Portfolio (SPLV), with $7.0 billion in AUM.

We’ll then compare their value metrics to those of the iShares Russell 1000 ETF (IWB), which is a market-oriented fund, and the iShares Russell 1000 Value ETF (IWD). The table below is based on Morningstar data as of Sept. 7, 2017.

As you can see, valuations, whether based on price-to-earnings, price-to-book or price-to-cash flow, are higher for the low-volatility strategies than for the market and Russell 1000 Value strategies. This indicates the popularity of low-volatility strategies has caused their prices to rise and, therefore, exhibit lower forward-looking return expectations.

Conclusion

Both theory and historical evidence demonstrate there isn’t anything unique about dividends. They are just another source of profit, along with capital gains. Yet many investors treat these two sources of profit very differently, with negative consequences in terms of lower returns, greater risks and less diversified portfolios.

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