In two previous articles, I have highlighted two simple buy-and-hold strategies that have beaten the S&P 500 (NYSEARCA:SPY) over the last twenty-plus years. Combining these strategies has beaten the broader market consistently over time, and this streak has continued in 2013.
The Dividend Aristocrats, S&P 500 constituents which have paid increasing levels of dividends for at least twenty-five consecutive years, have produced a return profile exceeding the broader market by 2.71% per annum while exhibiting only roughly eighty percent of the return volatility since 1989. The SPDR S&P Dividend ETF (NYSEARCA:SDY) has historically most closely replicated the Dividend Aristocrats, but on Friday, ProShares launched the ProShares S&P 500 Aristocrats ETF (NYSEARCA:NOBL), which is targeted to replicate the S&P Dividend Aristocrat Index that has produced the return profiles below.
The outperformance of the S&P 500 Dividend Aristocrat Index has continued in 2013, outperforming the S&P 500 by 118bps.
The S&P 500 Equal Weight Index is a version of the S&P 500 where the constituents are equal weighted as opposed to the traditional market capitalization weighting of the benchmark gauge. Guggenheim S&P 500 Equal Weight ETF (NYSEARCA:RSP) replicates this alternative weight index. When the equal-weighted version of the index is rebalanced quarterly to return to equal weights, constituents which have underperformed are purchased and constituents which have outperformed are reduced, a contrarian strategy that has produced excess returns relative to the capitalization-weighted S&P 500 index over long time intervals. Equal-weighting also gives an investor a greater average exposure to smaller capitalization stocks, a risk factor for which investors have historically been compensated with higher average returns. Since 1989, the equal-weighted S&P 500 Index has beaten the more popular capitalization weighted market index by 192bps per year.
In 2013, the equal-weighted index has continued its outperformance, besting the broad market index by 417bps.
The Dividend Aristocrats produced their relative excess return versus the S&P 500 in falling markets (see 2002, 2008), and the equal-weighted index produced its relative excess returns in rising markets (see 2003, 2009); combining their return profiles produces a risk profile that exceeds the broader market with substantially less variability of returns. Combining these two strategies in equal proportions has bested the S&P 500 in eleven of the past twelve years, and continued to outperform thus far in 2013 as both indices are beating the S&P 500 this year. Singularly, the Dividend Aristocrats have beaten the S&P 500 in nine of the past twelve years, and the Equal Weighted Index has beaten the S&P 500 in nine of twelve years as well, but combining the two passive strategies in equal proportions has led to even more consistent outperformance.
How good has the outperformance of this strategy been? Any active fund manager beating the market for 11 of the last 12 years would have made himself a lot of money. The geometric average return of this strategy (+7.73% from 2000-2012) beat the S&P 500 (+1.66%) by over 6% per year while exhibiting lower return variability. An equal combination of the Dividend Aristocrats and the equal weighted S&P 500 would have beaten the broader market by 2.7% again in 2013. Over this historically weak period for stock returns, a dollar invested in this strategy in 2000 would be worth $3.25 today, while a dollar invested in the S&P 500 would be worth less than half that figure, just $1.40, even as we approach a new all-time high yet again.
Critics of this strategy would point out that from 1990 to 1999, the S&P 500 outperformed a fifty/fifty mix of the Dividend Aristocrats and the Equal Weighted Index by 2.92% per year. I would counter that this outperformance by the broad market gauge was entirely generated by the S&P 500 returns in 1998 and 1999. High flying returns of tech stocks, which were not represented in the Dividend Aristocrats because of the long tenor inclusion rules, benefited the capitalization-weighted index. These two years marked the peak of the tech bubble, which subsequently unwound itself between 2000 and 2002 when the market produced three negative returns in a row. Taking out 1998 and 1999 from this dataset, and a combination of the Dividend Aristocrats and Equal Weighted Index still outperformed the S&P 500 between 1990 and 1997 (geometric average return of 16.98% vs. 16.63%) with slightly lower variability of returns.
I am pretty confident in saying that over the next ten years, a combination of the Dividend Aristocrats and the Equal Weighted Index will have lower variability of returns than the broader market as we have seen thus far in 2013. Because the Dividend Aristocrats Index is populated by companies that are able to return increasing levels of cash to shareholders through both the peaks and valleys of the business cycle, this index has lower drawdowns in weak markets. In each of the five years that the S&P 500 produced negative returns in this sample period, the Dividend Aristocrats outperformed. Combining the Dividend Aristocrats with the equal weighted index, which tends to outperform the market when it is sharply rising, provides a diversification benefit.
If we believe that this strategy will have lower relative risk to the broad market, will this strategy continue to generate excess returns? I believe that the Dividend Aristocrats will produce excess returns when adjusted for their lower risk over long time intervals. This strategy effectively overweights these high quality companies, capturing the Low Volatility Anomaly, and missing S&P 500 constituents who go out of business.
I am sure that some astute readers will note that the Dividend Aristocrats have outperformed the combination with the Equal Weighted Index over the entire dataset. While their risk-adjusted performance will remain strong, I do not expect that low volatility stocks, like the Dividend Aristocrats, will continue to outperform the broader market on an absolute basis.
The Dividend Aristocrats have now outperformed the S&P 500 for five consecutive years, and the market might be catching up to the idea that lower risk stocks are worth a premium, especially in uncertain market environments. While the Dividend Aristocrats have still outperformed in 2013, low volatility stocks, which have been negatively impacted by higher interest rates, have actually trailed the broader market. From the graph below, you can see the pivot towards underperformance when interest rates started to increase in early May.
Source: Bloomberg, Standard and Poor's
Equal-weighting the stock constituents provides an uncorrelated source of alpha with the Dividend Aristocrats. As I have written before, equal-weighting the S&P 500 constituents is an alpha-generative contrarian strategy that also more effectively captures the "small cap premium" than the capitalization weighted S&P 500, and I think that this part of the strategy will be an increasing component of its outperformance prospectively.
For passive investors who want broad market exposure, understanding that changing your index weightings to a combination that overweights dividend growth stocks and equal-weights the broad market benchmark has historically produced higher average returns with lower variability of returns.
Disclosure: I am long RSP, SDY, SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.