Assets are flowing into dividend-stock funds, as income-seeking investors look for alternatives to the low yields in the fixed-income markets. But many experts are warning that those investors are setting themselves up for significant losses. Using an objective methodology that assesses tradeoff between yield and risk, we can determine those funds that investors should prefer – and a few they should avoid.
One crucial thing about dividend-focused investing is that it is driven in large part by aging baby boomers, whose goal it is to construct de-accumulation portfolios with predictable income and low volatility. In addition, market volatility in recent years has made steady dividend payments especially attractive.
Those experts who caution against dividend funds warn that older investors are replacing low-yield bonds in their portfolios with riskier dividend stocks, inadvertently increasing portfolio risk at a point in their lives when they should be doing the opposite.
I will start by examining the key arguments in favor of dividend-oriented investing. I then explore the major classes of dividend-generating ETFs and mutual funds and compare them using a methodology that compares risk to yield, ultimately determining whether the higher yields that they offer justify the risks.
Elements of dividend investing
Dividends have historically made up a substantial portion of the total returns from equities. A recent article by Richard Skaggs, chief equity analyst at Loomis Sayles, provided updated statistics. Over the past 30 years, for example, dividends have provided 45% of the total return from the S&P 500.
While many advisors focus on total return, my research shows that six factors justify favoring dividend-paying stocks:
- Better estimation of risk for returns
- More rapid verification of return and yield estimates
- Higher quality of earnings
- Better alignment of incentives between corporate executives and shareholders
- Simplicity for retirement investors
- Increased attractiveness if the New Normal plays out
To estimate the future returns from any investment, one of the important sources of uncertainty is estimation risk. This is the risk that comes from our limited ability to estimate expected returns. Given that future returns are connected to future earnings, the research that shows that dividend-paying stocks have higher-quality earnings indicates there is less estimation risk associated with dividend-paying stocks than non-dividend payers.
A related advantage to dividend investing is what I refer to as verifiability. If I create a stock portfolio with an expected annual average return of 8% per year, I may have to wait for a very long time before I can confirm that my expected return figure was correct. If the portfolio –loses 8% in the first year, market volatility is likely to blame – but it will take several years to tell. Dividend-paying stocks sidestep this problem by providing returns via income that are verifiable quarter-by-quarter. If I hold a dividend-paying portfolio that does not provide its estimated 6% yield, there is clearly something wrong with my expectation.
Managers at firms that pay dividends have financial incentives more aligned with the interests of investors than those of executives at other companies. Management will focus on maintaining dividends, whereas at non-dividend paying companies, managers are more likely to hold substantial stock option grants. Because they are judged on the basis of price appreciation, and because their stock grants give them an incentive to focus on short-term price gains rather than long-term earnings quality, these managers are more likely to take risks.
It also helps that dividend-paying stocks are a key component of income portfolios, which are gaining popularity in de-accumulation strategies. Many retirees want to consume only the dividends or other sources of income generated by their portfolios, in order to reduce the risks of totally depleting their portfolios.
Finally, dividends will be attractive if the New Normal worldview described by Bill Gross and Mohammed El-Erian plays out. This outlook suggests economic growth will slow in the developing world, and that asset returns will be more modest that their historical norms. Accordingly, investors will favor dividends and drive up the prices of those stocks.
The major problem for dividend investors, however, is that dividend yields rise when companies are in distress. Facing adverse conditions that cause its stock price to fall, a company will be reluctant to cut its dividend, fearing the negative signal to investors. With a constant dividend payment and a falling stock price, yield rises. Very high yields can be a sign of distress and warn of an impending dividend cut; this is the so-called value trap.
Against this backdrop, let’s explore the mutual funds and ETFs that focus on dividend stocks.
Funds for exposure to dividend stocks
The simplest way for investors and advisors to invest in dividend-paying stocks is through ETFs or mutual funds. Currently, those funds have yields as high as 6.8%, but those high-yield funds come with risks. The question is whether the risks associated with higher-yield alternatives are too high. Examining the range of dividend-focused ETFs provides an answer.
ETFs
Index-based ETFs, such as the SPDR S&P Dividend ETF (SDY) and the Powershares High-Yield Equity Dividend Achievers ETF (PEY) provide a good starting point to explore dividend funds. PEY has a yield of 3.66% and SDY yields 3.11%. SDY tracks the S&P High-Yield Dividend Aristocrats index, which draws from a set of companies that have 25-year track records of maintaining and/or raising their dividends. PEY tracks the Mergent Dividend Achievers 50 Index, which contains domestic stocks with high current yield and consistent growth in dividends.
The yields on SDY and PEY can be used as a baseline for judging other dividend-paying funds. The SPDR International Dividend ETF (DWX), for example, nearly doubles their yields at 6.37%.
How do we compare the relative tradeoff of yield vs. risk between SDY and PEY and a fund like DWX? A simple but highly informative measure is to compare yield and historical volatility. The table below compares the yields of a number of stock ETFs with high dividends to their historical volatilities. I selected this list of ETFs using a screen for equity funds with the highest yields, also including a long-term Treasury bond ETF (TLT) for reference. This table is sorted from highest yield (top) to lowest yield (bottom).
High-yield dividend ETFs
What immediately jumps out is how important it is to look at volatility. DWX, for example, has much higher volatility than either SDY or PEY, both of whose risk and yield are remarkably similar to those of the long-term Treasury bonds.
The S&P 500 has a trailing 3-year volatility of 15.6%, which provides a risk benchmark. Quite a number of these funds have been much more volatile than the S&P 500.
One note for the close reader of the table above: CVY, an ETF with high yield relative to its risk level, is not a pure equity fund. The fund holds preferred shares, MLPs, and mortgage REITs. Any of the pure equity funds in the list above could generate more yield with the same or lower risk if they were allowed to invest in these asset classes.
Mutual funds
I have performed a similar search to select dividend-focused mutual funds; the same data for these funds can be found in the table below.
High-yielding dividend mutual funds
The first two funds, HFQAX and EDIAX, have more than twice the yield with only slightly higher risk than SDY. Morningstar classifies HFQAX as a world stock fund with a large value style. It holds 2.6% in cash, 17.9% in U.S. stocks and 79.6% in non-U.S. stocks. On the basis of yield-vs.-risk, this fund is impressive. EDIAX is also classified as large value fund. A concern with these two funds, however, is their very high annual turnover (127% for HFQAX and 124% for EDIAX ), which means that investors are relying on the fund managers’ ability, rather than on the persistence of dividends . High turnover also detracts from performance through brokerage costs and bid-ask spread for the fund’s trades.
The table above highlights why investors need to be cautious about selecting funds on the basis of yield alone. Oppenheimer International Small Cap fund, OSMAX, has a yield of 4.3%, far above that of the S&P500, for example, but the risk associated with this fund is substantial. Investors owning such a fund are implicitly betting on substantial price appreciation to supplement yield and offset the risk that they assume.
The risk versus yield frontier
I first introduced the idea of creating an efficient frontier for yield versus risk (as opposed to expected total return versus risk) in October 2010.
Overall, the spectrum of risk versus yield for mutual funds is very similar to that for ETFs, as we can see in the chart below.
Risk vs. Yield for the ETFs and Mutual Funds (larger circle is long-term Treasury ETF)
The available yield increases with the risk of funds up to volatility (in other words, risk) of 15%-18%. As risk increases above this level, the available yield starts to drop.
There is a natural maximum yield that is available to fund investors. Adding risk to a portfolio by adding higher-risk assets reduces yield once you pass a specific risk level, because the fundamental nature of the stocks changes. High-risk stocks (such as technology stocks, for example) are less likely to pay substantial dividends, as their high volatility and low dividend payouts reflect the uncertainty of their future earnings .
The chart above also depicts the efficient frontier of yield versus risk for ETFs and for mutual funds. The solid blue line on the chart (labeled ETF Frontier) represents the maximum yield available at a given level of risk by combining the dividend ETFs to form a portfolio with a specific level of risk, then optimizing those combinations for yield. The mutual fund frontier is very similar (shown as a solid red line).
I have limited the maximum allocation to any single fund to 50%. This is somewhat arbitrary, of course, and lower maximum allocations allowed for the optimization will result in lower maximum yields. The maximum yield portfolios are generated using Quantext Portfolio Planner.
The maximum-yield mutual fund portfolios (red curve) have a consistently higher yield than the equivalent ETF portfolios. It is important to bear in mind, however, that the yield-versus-risk measure does not account for the impact of fees, which tend to be higher for mutual funds.
The S&P 500 has trailing 3-year volatility of 15.6%, so the results above mean that it is possible to create a portfolio out of the ETFs from the table above with a yield of 6% and the same volatility as the S&P500, even with the 50% maximum allocation constraint. This portfolio has the following allocation:
50% IST
37.5% IXP
12.5% CVY
A portfolio that is 50% allocated to each to HFQAX and EDIAX (the two dividend-focused mutual funds discussed earlier) has trailing volatility of 14.9% and a yield of 6.6%. If we exclude these two funds from the sample of mutual funds and then optimize to get the highest yield possible for a volatility of 15%, the maximum yield is 5.6%. The ETF efficient frontier has a yield of 5.8% at this risk level.
These optimized results do not mean that these are the best portfolios on a going-forward basis, but they do illustrate that investors can do better than the yield and risk of the S&P 500 using a portfolio of dividend-focused funds or ETFs. In general, investors prefer to constrain the maximum allocations to any given fund or asset class far more than I have in these examples.
Investors must recognize the enormous range of volatility for equity funds with a specific yield. There are funds whose yields approach 5% with volatilities below 15% and others with volatilities as high as 30% or more. Investors whose primary consideration is income should avoid funds with volatilities greater than 20%.
The fact that a fund is not close to the efficient frontier does not rule it out as an attractive portfolio component, however, because even a higher-volatility, lower-yield fund may have positive diversification effects. This would result in a portfolio with improved yield vs. risk even if one of the funds is not terribly attractive on a standalone basis. Furthermore, there are many classes of stocks with high growth potential that pay small dividends or no dividend at all. The yield-versus-risk frontier pertains only to the component of return represented by income.
Conclusions
With Treasury yields near all-time lows, many investors are chasing yield and pouring money into dividend-oriented stock funds. The perils of doing so are evident from the level of risk in many of the funds above. A fund that has “dividend” in its name may still be very risky. On the other hand, there are good reasons to prefer dividend-paying stocks.
Even if one does not believe higher-dividend stocks will provide higher returns relative to risk, investors should still favor them on the basis of higher earnings quality and lower estimation risk for future returns. In the case of funds with high volatility, however, dividends will typically be a smaller component of total return, so this value proposition is less compelling.
Even in the current low-yield environment, one can create a portfolio of equity funds with a yield as high as 6% and the same level of historical volatility as the S&P 500. Investors seeking yield indiscriminately, however, may end up with considerably more risk than they expect. Historical risk values for mutual funds and ETFs are readily available from Morningstar, and one can compare a fund to its benchmark and alternatives. Any dividend-fund investor should do his or her homework first – then prepare to be pleased with the results.
Appendix : Funds sorted on yield / risk
Geoff Considine is founder of Quantext and the developer of Quantext Portfolio Planner, a portfolio management tool. More information is available at www.quantext.com.
Geoff’s firm, Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com), an innovative brokerage firm specializing in offering and trading portfolios for advisors and individual investors.
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