The rising demand for investment income has fueled a proliferation of exchange-traded funds geared toward dividend-paying stocks.
According to etfdb.com, investors currently have no fewer than 25 options from which to choose. While this wide array of options make the decision-making process more difficult, investors can quickly narrow their options by focusing on dividend growth rather than absolute yield.
At first glance, this might not seem like the best approach. iShares Select Dividend ETF (DVY), which focuses on the highest-yielding stocks, has a stated yield of 3.62%. In contrast, Vanguard Dividend Appreciation ETF (VIG) yields just 2.19%. This 1.4-percentage-point shortfall would seem difficult to overcome, particularly when compounded over a longer time frame.
In reality, however, the opposite is true: By giving up some income, investors can take advantage of the superior total return potential of dividend growers. Goldman Sachs dug into the numbers for its May 2013 white paper titled “Why Dividend Growth Matters,” which analyzed stock market data from 1972-2012. The paper shows that $100 invested in the S&P 500 would have grown to $1,622 over that interval, while the same amount invested in “All Dividend Paying Stocks” would have expanded at nearly double that rate, to $3,104.
But that same $100 invested in “Dividend Growers & Initiators” did even better still, growing to $4,169. Notably, the Grower category experienced less volatility than either of the other two groups, meaning that its risk-adjusted returns were even better than the headline number.
The Underpinnings of Outperformance
Why would the Growers & Initiators group perform so well? The authors of the Goldman piece provide the answer:
“One reason is the potential for the total return value of the stock to increase just from dividend growth alone … If you were to buy a stock when the dividend yield was 3% and the company raised its dividend 15% per year for five years, the dividend yield on the original investment would double to 6%.”
“Another possible explanation for their historical greater long-term total return is that a company that can grow its dividend must have:
- A business capable of generating strong and growing free cash flow.
- A management team that is disciplined in its use of cash and focused on shareholders.
As a result, we believe investors want to own these successful, shareholder-oriented companies, thereby contributing to the share price appreciation over time.”
ETF Returns Support the Goldman Thesis
Unless current income is the primary consideration, investors’ first gauge in assessing a dividend ETF should therefore be to find those focused on growth, rather than absolute yield. Since inception in May 2006, VIG has provided an average annual return of 6.77%, beating the 4.15% registered by DVY.
The results are similar for the SPDR S&P Dividend ETF (SDY), which — like VIG — tracks an index that uses past dividend growth as a criterion for the construction. Since May 2006, the fund has returned 6.62%. Much of the shortfall relative to VIG is accounted for by expenses, as SDY charges 0.35% versus VIG’s 0.10%.
Investors also can choose WisdomTree U.S. Dividend Growth Fund (DGRW), which focuses on the potential for dividend growth in the future rather than building its portfolio on the basis of past dividend growth. The fund just opened in May, however, so the strategy still needs time to prove itself.
Dividend Growers Often More than Just Higher Returns
The superior performance record isn’t the only benefit of focusing on dividend growth over yield. Funds with an absolute-yield tilt tend to have greater sector concentration than those invested in dividend growers. DVY, for instance, holds a weighting of nearly 30% in utilities and another 33.8% in industrials and consumer goods. In contrast, VIG — while certainly more concentrated than a broad-based index fund such as the SPDR S&P 500 ETF (SPY) — offers a much broader portfolio.
The concentration of absolute-yield funds makes them more vulnerable to rising interest rates. During the selloff in income-generating assets that ran from May 22 through June 24, DVY shed 5% and slightly underperformed the broader market. This is a very small sample, but it hints at the potential impact that a rising-rate environment could have on the highest-yielding stocks.
Finally, the timing could be right for a focus on dividend growers to pay off. In its July 26 research note, Bank of America Merrill Lynch notes that dividend growth stocks are near their cheapest valuation relative to high-dividend yield stocks in the past 23 years. Among the individual dividend growers to which it has awarded “buy” ratings are Cisco (CSCO), Microsoft (MSFT), General Electric (GE) and Pfizer (PFE).
The Bottom Line
Dividend stocks remain in high demand, and with good reason. But investors who are looking to generate the biggest bang for their buck over the long-term would be well-served by honing their focus on dividend growth over absolute yield.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.