Why I’m not a “dividend investor”

by rao-blackwell-ized

First, let’s define what we’re referring to here. There’s a strategy in which dividend growth – a company increasing their dividend payment over time – is used as an indicator to identify strong, stable, successful companies to invest in. There is nothing inherently wrong with this, and could even potentially allow you to beat the market (though historically dividend yield per se has actually been shown to be a suboptimal indicator of value, and is not an empirical factor that influences stock performance), as buying high-dividend-yield and dividend growth stocks incidentally gets you exposure to empirical equity factors like Value, Quality and lower volatility in likely-mature, conservative companies. This is actually a big part of how Warren Buffett picks stocks.

There are funds that aggregate these exact types of stocks, and they sometimes ironically have a lower dividend yield than a broad index fund. Vanguard’s VIG is the most popular one. However, recent research has shown this is still probably not the optimal approach. We’ll dive into these funds and that research more specifically later.

What I’m referring to, and what I see more often, is what are sometimes called dividend chasers – those seeking out individual high-dividend-yield stocks or funds for the sake of the dividend itself, which is usually what’s being referred to any time you see any of these words or phrases in relation to an investing strategy:

“Income”
“Passive income”
“Income investing”
“Dividend investing”
“Living off the dividends”
“$X per month”

For the sake of clarity, in this post I’m referring to chasing dividend yield as “dividend investing” or “dividend chasing,” and I’m referring to investing in companies that have a history of increasing their dividend over time as “dividend growth investing.” It’s a subtle but important distinction, and the different terms are sometimes thrown around interchangeably, adding to the confusion.

I get it. Dividend chasing as a strategy is easy to sell, and proponents are good at selling it, either sweeping the data and math under the rug, ignoring it altogether, or simply not knowing it in the first place. I can see the attraction at first glance – predictable cash payments into your account while keeping the same number of shares. Sounds great!

In fairness, I suspect most novice investors also simply don’t know some of the underlying mechanics that can make dividends per se drag down your net total return, which is what you should always be focused on. What saddens me is these same novice investors will likely see pro-dividend-chasing blogs and videos and jump in without hesitation, screening for high dividend yield stocks and throwing them in their portfolios.

Here are the reasons why I don’t chase dividends:

1. Dividends result in a larger tax burden.

Arguably the most important point here, but one that I think is often misunderstood and simply repeated platitudinously. If you’re holding dividend-paying assets in a taxable account, you are invariably paying more in taxes than if you were holding non-dividend-paying assets. If you are chasing dividends, you are consciously paying more in taxes than you have to.

Whether you call it a “dividend” or “withdrawal” or “income” doesn’t matter; it is a taxable event. Period. Even if your dividends are reinvested (in which case, what’s the point of chasing them?), they’re still taxed upon distribution. Thus they create a net loss in taxable accounts compared to the same securities if they didn’t pay a dividend.

Imagine selling shares of stock and immediately buying them back at the same price. You have accomplished nothing, but you’ve been taxed as a result. This is precisely how dividends work in a taxable account.

One of the pro-dividend points often raised in regard to taxation is that qualified dividends are taxed at a lower rate, which is true. Unfortunately, dividend chasers, in going after high yields, end up holding things like REITs in their taxable accounts, which distribute non-qualified dividends that are taxed at marginal income tax rates.

Moreover, even qualified dividends are taxed at capital gains rates, which is what you would pay anyway when you sell shares. Selling shares at the LTCG rate to realize only the withdrawal amount you actually need, when you need it, allows you to postpone that taxation. Also, if the amount of your withdrawal is lower than the forced periodic withdrawal of your dividends, you’ll pay less in taxes.

This is why I always try to stress that dividend-paying securities, especially high dividend payers like REITs, should not be held in a taxable account if you can avoid it. Specifically, put high dividend yield assets in a tax-advantaged retirement account where they can do no harm, turn on automatic reinvestment, and use growth stocks (growth stocks pay no or low dividends) and municipal bonds (tax-free) in your taxable account.

2. Dividends are not “free money.”

A company’s or fund’s dividend has already been intrinsically factored into its value and subsequently, its share price. That is, it has already been “priced in.” Markets are efficient. You are not gaining anything extra by receiving a dividend. $1 is $1 is $1; there is no free lunch in the market.

For a simplistic, hypothetical example, let’s say you own Company ABC and you transfer $1 from its company bank account to your personal bank account. Your net worth has not increased as a result; you own the company, so you owned that $1 the whole time. You’ve just subtracted it from somewhere – in this case the company’s value – and added it somewhere else – your pocket.

Similarly, your partial ownership of a different company (in the form of shares) may be worth $1 that the company holds. Upon transferring it to you in the form of a dividend, you are no wealthier as a result, as the company’s value has just decreased by the amount of its dividend payment. Specifically, with the dividend, you own more shares at a lower price. Without the dividend, you own fewer shares at a higher price. They are identical. Here’s a graphical summary of this concept.

Essentially, you are being paid with your own money. This concept is similar to how some people get excited about receiving a tax refund each year. It was your money all along.

3. Dividends limit total returns.

Because of the nature of #2 above, you are effectively withdrawing money from your account each time a dividend is distributed. If they are not reinvested, you have now taken out capital that could have been left in to appreciate more, ultimately actually lowering your total returns. That is, those dividends are missing out on the compounding. This is another hugely important distinction in considering whether or not to reinvest dividends.

For a simplistic, theoretical, ad hoc example, if you bought 1 share of Company A at $100 and it increases by 10% to $110, your unrealized return is 10%. Company A does not pay a dividend. Let’s suppose you also have 1 share of Company B, which also has a share price of $100, and that Company B just paid you a $1 dividend that you chose not to reinvest but take as income. Company B also grew by 10%. Company B’s share price is now $99, which has now grown by 10% to $108.90. Adding in your $1 dividend distribution you took equals $109.90, for a total return of 9.9%. Your initial investment capital is the same in both examples, yet your total return on Company B is lower than Company A.

Disregarding taxation, we could even simplify that example and exclude the 10% growth aspect to show that $100 in Company A = $99 in Company B + $1 dividend, meaning the dividend puts you right back where you started. At scale, in the market as a whole, this is all usually happening somewhat invisibly behind the scenes, but rest assured it is happening. Again, $1 is $1 is $1.

Had you put $10,000 in an S&P 500 index fund in 1985 and let it sit for 34 years through 2018 without adding anything and reinvested the dividends, you would have ended up with $314,933 for a total return of 3049%, an effective CAGR of 10.68%. Without reinvesting dividends, you would have ended up with capital appreciation of $118,556 and dividend payments of $37,394 for a total of $155,950 and a total return of 1460%, an effective CAGR of 8.41%. That’s less than half the return!

As another simplistic, somewhat extreme but very telling example, “A Single Share of Coca-Cola Bought for $40 in the 1919 IPO With Dividends Reinvested Is Now Worth $9,800,000 vs $341,545 Without Dividends Reinvested.” Source here.

These examples still do not even factor in the tax on the dividends you took as income. Pre-tax returns of dividend-paying and non-dividend-paying stocks are identical (which is why dividends are harmless in a retirement account if reinvested), but taxation invariably, unequivocally results in a lower total return for the dividend investor in a taxable account.

Compound these issues across many stocks with much more money over many years and you can see the huge problem this creates. We’ll illustrate this specific problem with some more realistic examples later.

4. Dividends are a forced withdrawal.

Extending #3 above, dividends are simply a withdrawal forced upon you by the very company you’re invested in. If you’re truly investing with a long time horizon, chances are you don’t need the dividend distribution as income monthly, quarterly, or even annually. Even if you did, you could simply withdraw what and when you wanted as discussed above.

Instead, dividend distributions force you to withdraw money at regular intervals regardless of whether or not you want to. This can be particularly problematic if you are purposely trying to keep your taxable income low in a specific year.

5. I don’t want dividends.

With a company’s earnings, they can choose to pay for things like R&D, future projects for growth, and mergers and acquisitions. If they are in a position in which they can do none of those things, they can return value to shareholders via dividends or stock buybacks. On average, all these things achieve the same net result for shareholders.

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If I’m invested in Company A, the dividend is the last outcome I want out of the aforementioned options. After all, I’m invested in Company A because I think it will grow! Warren Buffett, arguably the most respected investor in history, feels the same way, which is why Berkshire Hathaway doesn’t pay a dividend.

I would also argue that share repurchases are slightly better than dividends anyway, given that you’re essentially taxed twice on dividends since the company [hopefully] had to pay corporate income taxes on that cash.

6. Dividends only possess a psychological benefit.

This is the reason why I think dividend chasing intuitively seems attractive at first glance and why many people illusively buy into it as a strategy. It simply feels good to have cash show up in your account regularly and predictably. This part I understand somewhat.

Hersh Shefrin and Meir Statman actually looked into the phenomenon of dividend preference in 1984. They found 2 main reasons why some investors chase dividend yield: 1) those investors recognize they are unable to delay gratification and adopt a “cash flow” approach to pay for regular expenses, and 2) the psychological principle of loss aversion causes investors to prefer the feeling of receiving a dividend over “losing” shares in order to realize capital gains of an equal amount.

I try to stay pragmatic and scientific with my investing and leave emotions out as much as I can. If for some reason the mental accounting fallacy of dividend chasing keeps an investor more disciplined or lets them sleep better at night than selling shares in a buy-and-hold strategy would, then I’d have to support it. I would rather see someone chase dividend stocks than penny stocks.

7. Dividend chasing decreases diversification.

By solely chasing dividend stocks, you’re missing out on roughly 60% of the US market, thereby posing a concentration risk and resulting in a lack of diversification, especially considering that 60% contains nearly all the small-cap stocks in the market, as small-caps usually don’t pay dividends. This also means you’re missing out on the potential outperformance of that 60%, which is of some significance considering small-cap value stocks have outperformed their large-cap counterparts over time.

Second, there is no sound evidence that dividend-paying stocks are any better – in terms of total return – than non-dividend-paying stocks. Remember, the dividend itself does not account for a stock’s performance.

Lastly, we know that picking individual stocks is extremely unlikely to outperform a broad market index over a time horizon of 30+ years anyway.

8. Dividends are not guaranteed.

Dividend investors usually like to claim that their predictable dividend payments will still be there during market turmoil. This is not necessarily true. Companies can decrease or eliminate their dividend payment at will.

Even worse, companies will sometimes borrow in order to pay their dividends so as to not spook shareholders by decreasing or eliminating the dividend, in which case you effectively just borrowed with interest to pay yourself your own money.

Of course, Merton Miller and Franco Modigliani figured all this out in 1961, so it’s frustrating to see the myths of dividend chasing and “income investing” persist. Again, I suppose since it’s an active strategy, it’s easier for people to create blogs and YouTube videos and newsletters around it and make money providing information to people who are new to investing or who may not know any better. It’s also a lot more exciting than saying “Buy VTI and don’t touch it for 30 years.”

So now let’s circle back to our first “type” – “dividend growth” investing – and look at some specific funds. Again, note that I am in no way against this strategy of investing in stocks with a history of increasing their dividend over time (“dividend growth“). It may allow you to beat the market in the long run.

VIG is probably the most popular of this type, and rightfully so. It “seeks to track the performance of the NASDAQ US Dividend Achievers Select Index (formerly known as the Dividend Achievers Select Index).” So it focuses on large-cap blend stocks with a history of dividend growth (increasing their dividend payment over time). There’s also an international version, VIGI.

Dividend chasers seem to like VYM due to its yield. It “seeks to track the performance of the FTSE® High Dividend Yield Index, which measures the investment return of common stocks of companies characterized by high dividend yields.” So here we’re looking at large-cap value stocks that happen to have a high dividend yield, not necessarily an increasing dividend over time. I think because of that fact, because Growth has outperformed Value in recent years, and because tech has performed well in recent years, VIG has crushed VYM recently. Granted, because VIG is looking at dividend growth and VYM is looking at the dividend yield per se, these funds aren’t really the same thing.

Even with dividends reinvested, VIG would have given you an extra CAGR of 1.33% compared to VYM since VYM’s inception in late 2006. VYM also lagged the S&P, while VIG beat it and had a higher Sharpe ratio, better max drawdown and Worst Year figures, and less volatility. Interestingly too, VIG fared much better than both VYM and the S&P through the 2008 crisis and the recent Q4 2018 correction.

Despite offering these funds, Vanguard itself investigated the strategies contained in VYM and VIG and concluded, as I pointed out earlier, that the stocks’ performance was fully explained by exposure to equity factors like Value, Quality, and lower volatility. Specifically, the returns of high-dividend-yield equities are explained by the factors of Value and low volatility, and the returns of dividend growth equities are explained by Quality and low volatility. This is not a bad thing, just something to note – that the dividend payment itself is not responsible for the [out]performance of VIG compared to the S&P 500. Again, VIG may allow you to beat the market in the long run.

SCHD is another popular fund like VYM. Both have lagged the S&P since SCHD’s inception in 2011. This makes some sense when we look at the valuation metrics of these types of funds. Since the 2008 crisis, many investors have flocked to low-volatility funds to the point where the strategy has been “cursed by popularity.” The valuation metrics (source) for these are now higher than their “normal” Value ETF counterparts and the S&P 500 index, indicating lower expected future returns for these low-volatility funds.

DGRO from iShares should perform similarly to VIG, with slightly more volatility since it’s more inclusive with its 5-year-growth requirement instead of VIG’s 10-year. As a result, DGRO should have more exposure to comparatively smaller companies than those in VIG. Maybe slightly more reward for slightly more risk. It will be interesting to see going forward. Here’s a comparison of those. Nearly identical, with a tiny bit more volatility, though interestingly VIG had a worse max drawdown during the Q4 2018 correction. Unfortunately DGRO has only been around since 2014.

NOBL from ProShares claims to be the “only ETF focusing exclusively on the S&P 500 Dividend Aristocrats—high-quality companies that have not just paid dividends but grown them for at least 25 consecutive years, with most doing so for 40 years or more.” Its ER of 0.35% is much higher than VIG’s 0.06%. Like DGRO, NOBL may slightly outperform VIG over the long run, albeit with more volatility. Here’s a backtest comparing NOBL and VIG since NOBL’s inception in late 2013, using the S&P 500 as a benchmark. The S&P has actually slightly outperformed NOBL since then, though again the dividend appreciation ETF’s fared better through the Q4 2018 correction with smaller drawdowns.

I did run some of the other popular players in this space – SDY, SPLV, SPHD, DVY, etc. – but they were all very similar and I think VIG beat them on all performance metrics and has the highest AUM by far, so I’m sort of holding VIG as the gold standard in that category of dividend-oriented ETF’s. Though note that these others should have lower valuation metrics than VIG precisely because people are flocking to VIG.

For me, a dividend growth tilt retirement pie might look something like this (M1 pie link) – 90/10 equities/bonds, 10% int’l stock exposure, and 10% REITs – 8% US and 2% int’l.

But since we now know that dividend investing is essentially just a Value tilt and since the high-dividend low-volatility strategy is being “cursed by popularity,” you may be better off just investing in large-cap Value.

After spending much time researching the subject, Meb Faber succinctly summarizes these points as follows here:

Dividend yield investing is rooted in value investing.
Historically, focusing on dividend yields rather than value, has been a suboptimal way to express value.
If you have to focus on dividends, you MUST include a valuation screen or process to avoid high yielding but expensive, junky stocks.
The hunt for yield has caused dividend stocks to reach valuations levels never seen before relative to the overall market.
Since dividend stocks are currently expensive, we prefer a shareholder yield approach combined with a value composite screen.
Once you have a preferred value methodology, AVOIDING dividend stocks in the strategy could result in additional post tax alpha of approximately 0.3% to 4.5% for taxable investors.

He shows in this table (source) that investing in Value and avoiding high dividend payers (far right column) came out ahead in all taxable environments. EW stands for “equal weight.”

If anyone knows of any large-cap value ETF’s or mutual funds that consciously avoid high dividend payers, let me know.

TL;DR: If you’re set on dividend-orientation, I would say feel free to utilize dividend growth/appreciation stocks and ETF’s like these as a tilt, but please stop chasing dividends for the sake of the dividend itself, especially in a taxable account.

Specifically, hold high-dividend-payers like REITs in tax-advantaged retirement accounts and reinvest the dividends. Hold low- or non-dividend payers in taxable accounts, reinvest the dividends, and sell shares as needed for income.

Here’s some additional reading material on the subject if you’re interested:

Disclaimer: Consult your financial professional before making any investment decision.

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