Issues to Consider With a High-Dividend Approach

With the current low yields on fixed income securities, the financial media have produced many articles regarding high-dividend strategies. The following discusses two fundamental flaws with using these strategies as alternatives to either high-quality fixed income portfolios or to other equity strategies.

While the financial media tout high-dividend strategies as alternatives to other prudent investment strategies — such as equity strategies or high-quality fixed income portfolios — there are several issues you should consider. First, a high-dividend strategy is far riskier than a high-quality fixed income approach, so comparing the two is like comparing apples to oranges.

 

Second, it is well known within financial academia that a high-dividend strategy is essentially a value stock strategy, which is a strategy of buying companies that have low prices relative to earnings, book value, dividends or some other accounting metric. However, the high-dividend approach to a value stock strategy has historically had the lowest returns, and returns (meaning dividend payments plus capital appreciation) are ultimately what should matter.

 

The Risks of a High-Dividend Approach

The table below illustrates the historical differences in risks between a high-dividend equity strategy and a high-quality fixed income approach for the period of 1952–2009. For the high-quality fixed income approach, we’ll use the returns of five-year Treasury notes.

 

 

High-Dividend

Five-Year Treasury

Lowest Annual Return

–36.3%

–5.1%

Lowest Two-Year Total Return

–39.7%

–1.7%

Lowest Three-Year Total Return

–33.6%

1.6%

% of Years With Negative Returns

24%

14%

Annual Volatility

20.0%

6.4%

Sources: Dimensional Fund Advisors, Ken French

 

The increased risks of a high-dividend equity strategy compared with a high-quality fixed income approach are clear. For example, the lowest one-year return on the high-dividend strategy was
–36.3 percent, which occurred in 2008. This compares with –5.1 percent for the five-year Treasury strategy. So by no means do high dividends insulate you from the overall risk in the equity markets. It is also worth noting that the volatility of the high-dividend strategy was more than three times higher than the volatility of the five-year Treasury strategy. Our conclusion is that in no way should a high-dividend equity approach be considered a replacement for a high-quality fixed income portfolio.

 

Comparing High Dividend Strategies to Other Value Strategies

In academia, there are four well-known approaches that are considered to be “value” stock strategies:

  • Buying companies with low stock prices relative to accounting book value
  • Buying companies with low stock prices relative to earnings
  • Buying companies with low stock prices relative to cash flow
  • Buying companies with low stock prices relative to dividends

 

These four strategies are all very highly correlated with each other. For example, the high-dividend strategy has a correlation of 0.90 or higher with the other three strategies. The problem, however, is the high-dividend approach has historically had both the worst returns and the worst risk-adjusted returns of the four strategies. The table below shows the historical performance of all four strategies in the U.S. over the period of 1952–2009. Note that the Sharpe ratio is the standard measure for risk-adjusted return. A higher Sharpe ratio indicates better returns relative to realized risk.

 

 

Low Price-to-Book-Value Ratio

Low Price-to-Earnings Ratio

Low Price-to-Cash-Flow Ratio

Low Price-to-Dividends Ratio

Average Return

16.6%

18.4%

17.7%

13.7%

Volatility

22.4%

23.7%

21.6%

20.0%

Sharpe Ratio

0.51

0.56

0.58

0.44

Source: Ken French

 

Summary

Nothing in the historical data suggests high-dividend strategies are an appropriate substitute for high-quality fixed income or are the best way to gain exposure to value stocks. A high-dividend approach has substantially more risk than a high-quality fixed income approach and substantially lower returns and risk-adjusted returns compared with other value strategies.

 

Copyright © 2010, Buckingham Family of Financial Services. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio nor do indices represent the results of actual trading. To be distributed only by a Registered Investment Advisor firm. Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

 

 
 

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