The Use and Abuse of Dividend StrategiesAugust 24, 2015

by Robert J. MartoranaThe quest for yield has led to high valuations for dividend stocks and boom times for equity income funds. The problemcomes when investors use dividend strategies too aggressively or as a cure-all substitute for financial planning, assetallocation and risk management. But there are certain guidelines that have proven to deliver superior results whenconstructing a dividend portfolio.

The popularity of dividends is waning. Recent data for equity-income funds shows outflows and lagging fund performance.As interest rates rise and as the economic outlook becomes more conducive to growth, valuations are likely to come underfurther pressure.

I will look at the underlying justification for a dividend-based strategy and at how the most popular funds have performedrecently. I will then discuss the criteria that investors should use to construct the best dividend-oriented portfolio.

Dividend zealots

I’m a fan of dividend stocks. In fact, I used them liberally for my mom’s retirement portfolio, since dividends make sensewhen growth is sluggish and bond yields are low.

But I recognize the limits of the strategy. This is not a message that everyone wants to hear:

I have come to learn that Dividend Growth investors, which have also been disparagingly referred to as DividendZealots, are among the most optimistic investors in the universe. And in many ways, perhaps the mostmisunderstood. Dividend Growth investors often state that they are not concerned with drops in the price of theirstocks, but only that their dividends grow. For some reason, this offends certain people who apparently feel thatthis makes Dividend Growth investors arrogant and/or even ignorant.

What these detractors misunderstand in my judgment, is that the average Dividend Growth investor does notworry about short-term volatility because they do not intend to sell. Dividend Growth investors buy in order tohold quality dividend paying companies for the long run…”

Chuck Carnevale

NewsFlash: The Dividend Aristocrats Found The Lost Decade

Unfortunately, investors cannot ignore short-term volatility just because they “don’t intend to sell.” Life has a way ofsurprising us with events that suddenly require liquidity. A dividend investor could be a forced seller in a bear market, andthese losses are never recovered.

The pros and cons of dividend strategies

The first table below summarizes the pros and cons of dividend strategies from an advisor’s perspective. Dividendstrategies can be elegantly simple; they can be easy to design, execute and explain to clients. There is an activecommunity of dividend investors who share resources, which are shown in the second table below.

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Source: Right Blend Investing, LLC

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The biggest challenge for dividend strategies is that they are no substitute for holistic, goals-based wealth management.Dividends are useful screening criteria, but are no excuse for ignoring financial planning, asset allocation and riskmanagement. My experience with “dividend zealots” is that they overlook other financial solutions, such as incomeannuities, an excellent product for retirees seeking lifetime income. (See Wade Pfau’s article: Why Bond Funds Don’tBelong in Retirement Portfolios.)

As discussed in papers by Vanguard and Larry Swedroe, investors are better served by a total-return approach toinvesting. A total-return approach is indifferent to whether returns come from dividends, coupons or capital appreciation; allare equally desirable (at least on a pre-tax basis). By definition, this process results in a more robust portfolio than putting100% of investable assets into dividend stocks.

A total-return approach also considers risk management, even though investors are becoming less concerned about risk asmemories of the crash of 2008 fade. A long bull market has led to high valuations for dividend stocks, creating additionaldownside potential when a correction comes.

This is why the table lists a lot of “cons.” I like dividend strategies. But many investors are ignorant of the risks involved orunderestimate the negative consequences after a long bull market.

Returns and flows

The table below shows the returns for various Lipper classifications of equity-income strategies. These include dividendstrategies, most of which are included in the Equity Income Fund classification. Of the seven classifications shown, EquityIncome Funds is the largest by far, accounting for over 60% of assets as of 7/31/15.

Sources: Lipper, a Thomson Reuters company, Vanguard, Right Blend Investing, LLC

Notes: Performance shown is for primary share classes, and historical data include closed funds. "Average Return" (atbottom of table) assumes an equal weight for each of the 7 Lipper fund classifications.

Returns for each of these classifications lagged the S&P 500 during the one-year, three-year, five-year and 10-yearPage 3, © 2020 Advisor Perspectives, Inc. All rights reserved.

periods. Dividend strategies did not outperform the market during this time frame, though some academic studies haveshown that dividends are a value approach that generates alpha. (For a thorough discussion of dividends and returns, Irecommend the 2014 Advisor Perspectives paper from Geoff Considine, founder of Quantext.)

Estimated net flows for these funds turned negative during the 12 months ending on 7/31/15. Net flows for all sevenclassifications were -$18.3 billion, including -$12.5 billion for Equity Income Funds. This is a turnaround from 2014, whenall seven classifications had positive fund flows, with a total of $36.1 billion, including $8.9 billion for Equity Income Funds.The reversal of flows from positive to negative shows that dividend strategies are falling out of favor.

Turning to the five largest funds in the Equity Income classification, a similar pattern emerges. Most of the funds lagged theS&P 500, except for the Vanguard Dividend Growth Fund (VDIGX). This fund focuses on stocks with a record of at least10 years of increasing dividends, and it has an expense ratio of only 0.32%. VDIGX returned 12.1% over the last 12months vs. 11.2% for the S&P 500. VDIGX also beat the market over the last 10 years, with returns of 9.2% vs. 7.7% forthe S&P 500. VDIGX holds high-quality companies with modest growth in dividends, and it fared well in 2008. The fundexcludes REITs, and this may have also helped long-term performance.

The long-term chart of VDIGX shows the extent of its outperformance versus the S&P 500 over the last 10 years. Thesecond-largest fund is the T. Rowe Price Equity Income Fund (PRFDX), which has lagged the market for each of the timeperiods studied. (See charts below.)

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The performance of PRFDX diverged sharply from the S&P 500 during 2015. This trend was also evident in other largedividend funds, both actively and passively managed. One reason for the divergence is the large holdings of REITs andMLPs. The divergence may also be due to investor concerns about rising rates, which may help explain the outflows fromdividend strategies.

Sources: Lipper, a Thomson Reuters Company, Right Blend Investing, LLC, fund fact sheets.

Notes: Total Net Assets are for primary share class only. Returns for the Lipper Equity Income Classification include closedfunds, and attempts to minimize survivorship bias.

The best and worst equity income funds showed a wide range of returns: Returns in the five worst performing funds rangedfrom -6.8% to -17.7%, while those of the five best performing funds were between 12.2% and 13.0%. These are smallerfunds, and most of the return variance is explained by sector concentrations. Funds with exposure to REITs and energystocks fared poorly over the last 12 months, as did funds with foreign-stock exposure.

Sources: Lipper, a Thomson Reuters Company, Morningstar, Right Blend Investing, LLC, fund fact sheets.

Notes: Performance ranking is based on primary share class for each fund. Total assets and estimated net flows are in

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millions. There were 169 funds in the Equity Income Fund classification as of 7/31/15.

The total net assets for the Stock Dividend fund are as of 12/31/14 and net flows are estimated. The total net assets forthe Alps Emerging Sector Dividend Dogs ETF are as of 8/13/15.

There is little here to suggest that active management adds value when choosing dividend funds, and there is much tosuggest that chasing high-yield stocks eventually backfires. The bottom-performing funds had high weightings in MLPs,BDCs and REITs. One of the lessons that emerges below is that the highest-yielding stocks generally produce the lowestreturns. This came out of research by Marc Gerstein of Portfolio123.com.

Gerstein tested a number of dividend selection strategies and found that the highest-yielding stocks tend to underperform.Apparently, the market is very efficient at identifying firms with unsustainable dividends, so it makes sense to excludestocks with yields above a certain level. (I am not aware of any equity income fund that puts a “cap” on dividend yield, soinvestors are left to fend for themselves and create their own portfolios.)

Based on Gerstein’s preliminary findings, he ran a backtest to measure the performance of dividend-paying stocks withcertain characteristics. Gerstein noted that the criteria (shown below) are subjective, but he avoided the “data-mining andcurve-fitting trap.” His goal was to build a screen that would work with out-of-sample data (i.e., live performance).

Source: Portfolio123.com presentation, June 18, 2015

A naïve application of a dividend-based strategy leads to concentration of risk and unintentional side effects. It is thereforeworth creating a basket of dividend stocks to offer clients. The goal would be to offer low costs, high transparency andactive risk management; the potential for higher risk-adjusted returns would be an added benefit.

Implementation of a dividend basket would be easier for advisors who have a unified managed account (UMA) platform. Ifthe advisor has access to a “rep as PM” program, the dividend basket could be a separate sleeve that sits alongside ETFsand mutual funds.

The results of the backtest (below) show 10-year cumulative returns of 148% for the period ending June 1, 2015. This issimilar to the 141% posted by VDIGX for the 10 years ending July 31, 2015. Although these results are not directlycomparable, the construction of VDIGX and the backtest from Portfolio123 are very similar. Both emphasize other factorsin addition to dividend yield: financial strength, earnings quality and sustainability. This process does not generate themaximum current yield, but it does generate better long-term returns.

Backtest of Dividend Screen by Portfolio123:

Excludes Highest Yielding Stocks

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Source: Portfolio123.com presentation, June 18, 2015

Looking ahead

As we contemplate the impact of rising rates on dividend strategies, consider the market conditions that are driving the Fedto act. Tony Rodriguez, Co-Head of Fixed Income at Nuveen, recently described the outlook in Fixed Income in a RisingRate Environment. Rodriguez characterizes today’s economy as one of:

High credit spreadsModerately steep yield curveNormalization after unprecedented accommodationDivergent global growthDivergent inflation trends

The Fed is not tightening to fight domestic inflationary pressures, so rate hikes are likely to be slow and modest. Theimpact on interest rates will be felt more sharply on the short end of the yield curve.

If this view is correct, economic growth is likely to continue to muddle along, earnings growth will continue in the mid-singledigits and growth stocks will garner a premium. This is an environment where growth is likely to outperform value,especially if rising rates give yield-hungry investors more options at the short-end of the curve.

Right now, cash pays virtually nothing, and the normalization of interest rates would drain some of the appetite for incomeinvestments. This appetite has driven dividend stocks to high valuation levels, and this is now reverting to the mean ascash moves out of aggressive dividend strategies. Thus, it makes sense to consider more conservative dividend strategiesthat are high quality and diversified, rather than strategies that are high yield and concentrated.

All things considered, VGIDX is attractive. It is low-cost, well diversified, has a strong track record and is well positioned fora rising rate environment. Sometimes a simple solution is the best solution.

Robert J. Martorana, CFA has been an investment professional since 1985. He owns Right Blend Investing, LLC, whichfocuses on institutional research of liquid alternatives. He is the co-author of Alts Democratized.

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