Dividend Growth's Magic Is Beta, Not Dividends

by: Dale Roberts

Many are attracted to dividend growth investing as it offers the potential of market-beating returns with lower volatility. That led me to writing this article, "Dividend Growth, a Useful Distraction?" Research mentioned showed that dividend growth companies can beat the total market in total return over longer periods. It is certainly well documented that dividends play a large role in the returns of the large cap companies that dominated the broader market indices such as the S&P 500 (NYSEARCA:SPY) and the Dow Jones Industrial Average (NYSEARCA:DIA). But how can concentrating on companies that have a history of growing their dividends lead to outperforming the market?

Vanguard offers one of the most popular dividend ETFs. The Vanguard Dividend Appreciation Fund (NYSEARCA:VIG) is a dividend growth fund, it invests only in companies that have a history of increasing their dividends over many years. As per the index that it tracks, it also applies various value metrics that attempt to better ensure the quality and reliability of the companies' earnings and ability to continue to increase those dividends. Given the quality of the companies that VIG holds and perhaps its ability to find value due to its "formula", VIG has been a wonderful total return vehicle. It has outperformed the broader market by a considerable amount.

From inception in May of 2006 VIG has delivered in the area of 70%, SPY has delivered a 59.3% total return over that period.

As we can see from the chart from low-risk-investing.com, the VIG outperformance is largely due to the lower beta that was present in the market correction of 2008 through 2009. In fact, if we run the numbers from January of 2009 to present, VIG underperforms the market considerably, 98% vs. 119%. Here we see SPY leaping ahead of VIG.

Perhaps the ability of dividend growth stocks to outperform the broader market over longer periods has more to do with lower volatility than the reinvestment of those dividends. That said, the quality of the companies and the fact that they can pay and increase dividends on a consistent basis IS the main driver of that lower beta. Investors are willing to pay up for that quality and consistent dividend stream. The fact that they can continue to increase their dividends may be more important than the fact that they do increase their dividends.

The ability of a portfolio to hold up during a market correction can have a tremendous impact on short to mid-term results. If a portfolio falls by 50% in a market correction, the portfolio then needs to double to get back to square. A portfolio that falls by 20% obviously does not have a daunting mountain to climb.

We have seen the same phenomenon at work in our own Streetwise Portfolios at ING Direct. They offer a unique ability in real-world and in real-time to evaluate and study asset allocation and diversification. ING Direct Canada launched a series of three simple but well diversified index-based portfolios in January of 2008, just months before the markets began to melt down. Incredibly, from that launch date the portfolios with the most bond exposure (and lower volatility) are still in the lead with respect to total return. And the portfolio with 70% bonds and hence the lowest volatility in the 60% market correction is in the lead with an average total return of 4% per year. The Balanced Income Portfolio with 70% bonds and 30% stocks fell by only 9% in the market correction. The classic Balanced Portfolio with 60% stocks and 40% bonds fell by only 20%. The markets of course corrected by an incredible 60%, the greatest market correction in our lifetime.

I find it fascinating that it is taking our Balanced Growth Portfolio (25% bonds) so long to catch that under-muscled Income Portfolio. The Growth Portfolio had returns last year of 19.27% and it has 5-year average annual returns of 8.88%. Talk about the investor equivalent of the tortoise and the hare. I'm not suggesting for a second that a portfolio that includes bonds will typically beat an all equity portfolio over longer periods, but the above comparison demonstrates how volatility can affect total return in certain periods.

Given that, the main benefit of acquiring Dividend Growth companies or ETFs might be lower beta, more than dividend reinvestment. And of course there are traditional methods to lower beta beyond acquiring solid dividend payers, one can add some bond exposure as well. Bonds are historically the tried and true additive that reduces portfolio volatility. As I have stated recently, perhaps there is no better market correction insurance than long term treasuries (NYSEARCA:TLT). You can see how TLT has offered an inverse relationship to the broader markets in this article here.

Let's use VIG and TLT and see how the mix of a lower beta stock index and Treasuries made it through the recession. The portfolio here has 2/3 VIG and 1/3 TLT.

Above we see that the lower beta portfolio established such a lead from the bottom of the market correction that it created a large hill to climb for the broader market's SPY. It has attempted to close the gap, but every time it gets close the markets throw another curve ball and the lower volatility mix pulls ahead again. To use another analogy, this follows the plot of the Roadrunner and Coyote cartoon. When is the crafty Coyote gonna catch his prey? Stay tuned, this may take a while, or perhaps the super charged markets have their way in 2014?

From 2009 the low beta portfolio has a total return was 67.9%, under-performing the SPDR S&P 500 ETF's total return of 119.3%. That certainly demonstrates how difficult it is to make up for a severe correction in your portfolio. And that's certainly why time horizon (how long are you looking to invest?) is one of the crucial questions (along with risk tolerance) when deciding what portfolio construction is most suitable. Do you have the time to wait out a market correction? If your time horizon is under 10 years, you may certainly want to avoid the pure stock portfolio, and a move to dividend growth companies and perhaps a sprinkling of bonds may be in order. If your time horizon is 4-5 years, then you want to be in a more balanced position from 70% to 40% bonds. Market history says you'll have a good chance of being in positive territory when you need those funds.

And remember only true (mathematical) reason to embrace Dividend Growth in the accumulation phase is to seek and get that total return that beats the broader market. In the accumulation phase the only thing that matters is total return. When you hit that retirement date and start to harvest your investments for spending, the most important metric will be how much do you have to spend, and or how much do you have to go shopping for your income generating investments.

Keep in mind as well, that those who select their own Dividend Growth companies/portfolios (and are kind enough to make their returns public) are so far having trouble keeping up with the broader index. They are largely well behind the Dividend Growth ETFs when it comes to total return. To each his own, but I would recommend that most investors simply buy the Index or Dividend Growth ETF and match the investments to your risk profile. To go one step further if you have a high risk tolerance level you and have a long time horizon, you will likely generate even greater returns beyond the broader market (NYSEARCA:VTI) by investing in the total market that includes small and mid cap companies. From there it will be about the harvesting of income and investments in the draw down phase.

As I demonstrated in this article, "The Ultimate Income Portfolio", it is quite easy to transition to an income generating portfolio, even with the simple purchase of three ETFs. In that article I suggest Vanguard's (NYSEARCA:VYM) the multi asset class ETF from Guggenheim (NYSEARCA:CVY) and a sprinkling of the high yield bond ETF (NYSEARCA:HYG). As the article demonstrates this traditional approach to immediate income generation (and income growth) is likely superior to traditional dividend growth holdings. Many authors on SA have provided examples that would make it easy to beat my Ultimate Income Portfolio for immediate yield. There are many great articles on REITs, MLPs, BDCs and perhaps superior bond ETFs or traditional mutual funds. I used that simple mix for simplicity sake with respect to tracking income.

Final Thoughts.

Dividend Growth investing offers a unique opportunity to lower volatility and deliver total return that can potentially beat the broader market. While the last 7 years is just a snap shot, VIG's outperform of the markets moving through a market correction is due to a lower beta. Is this the pattern that has repeated itself over the last few decades allowing dividend growth stocks to outperform? It's possible, as there have been periods such as 1991 to 2006 when dividend growth has outperformed the market, but the dividends have contributed (to total return) well below their historical norms.

If outperformance is due to beta, then that would prove the sports analogy that sometimes the best offence is a great defense.

Disclosure: I am long DIA, SPY, VYM. 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. Dale Roberts aka cranky is a Streetwise Coach at ING Direct Mutual Funds. The Streetwise Portfolios offer index-based complete portfolios to Canadians. Dale’s commentary does not constitute investment advice. The opinions and information should only be factored into an investor's overall opinion forming process.