Investing for Yield: Total Return Implications

There have always been those who prefer to invest for equity income and those who prefer to invest for growth and capital gain. Growth investors often feel the dividends reduce the opportunity for total return. Since the reduction of federal taxes on dividends, the debate has intensified.

In the end, however, logic is irrelevant and only the market action counts. So rather than join the debate with logic, we decided to look at some market facts to see what’s what.

We separated the S&P 500 into four bands based on five calendar years 2002-2006. The four bands of 5-year dividend action were:

• No dividends
• Lower yields
• Middle yields
• Upper yields.

The table below shows the 5-year average yield and the range of 5-year average yields for each of the four dividend bands.

The next table shows the total gain over 5 years for each dividend band based on:

• Price change only
• Dividends received only
• Total gain, including price change and dividends received

Our conclusion is that investing for yield is not hazardous to your total return health. In fact, if you subscribe to the “bird in hand versus two in the bush” philosophy, investing for dividends could be seen as advantageous.

Of course, this analysis is only for 5 years and a longer period may show different historical results, and the future may see changed conditions. Nonetheless, for the time being, investing for yield seems to have some support from the S&P 500 data.

In 2005, David Blitzer, Managing Director and Chairman of the Index Committee at Standard & Poor’s said,

Since 1926, dividends have contributed nearly a third of the market’s total equity returns. As equity ownership becomes even more ubiquitous, and a growing number of retiring Americans seek income-generating assets, the importance of personal dividend income will increase.

We assume that in a declining market, moderate to upper yield stocks in the aggregate should experience less decline that those with no or low yield.

That is confirmed by the performance of the S&P Dividend Aristocrats index (proxy (SDY)), and the Dow Jones Select Dividend index (proxy (DVY)) compared to the S&P 500 (proxy (SPY)) over long periods that included the difficult years 2000-2002.

The Dividend Aristocrats index outperformed the S&P 500 in 8 of 15 years ending 12/31/2006, and outperformed the S&P 500 11.24% to 8.24% over 10 years, while the Dow Jones Select Dividend index outperformed the S&P 500 13.53% to 8.24% over the same 10 years.

Additionally the S&P Aristocrats and the DJ Select Dividend indices outperformed the S&P 500 on a 1-year and 5-year basis. Over 15 years the Aristocrats outperformed the S&P 500 as well (no data for the DJ Select for 15 years).

Lastly, and importantly, the Aristocrats exhibited lower 5-yr and 10-yr standard deviations and higher Sharpe Ratios than the S&P 500.

Those facts add up to an all-around victory for dividend investing in our view.

Note that we are fundamentally biased toward value investing, but the facts seem to support our approach in this instance. Of course, the counter argument is that all these data don't argue for dividend investing, but merely prove the well known fact that value stocks have had their turn at being on top --- and that now growth stocks will have their turn soon. Only time will tell, but we feel well grounded on our bias toward equity income.

Disclosure: Author does not own any stock listed in this article.

Comments

[silverking8:]

ADVDX is a better fund for dividend income. Yield of around 13% out paces other funds or etf's.

2007 May 15 01:00 PM

[QVM Group:]

Actually, ADVDX does not yield 13%. It's dividend yield is 2.9% (less than the dividend funds mentioned in this article). The "yield" you are referencing is a figure that includes other items such as captial gains. ADVDX may or may not be a superior investment -- we have no opinion -- it is not appropriate to contract dividend yield with total return.

2007 May 15 04:10 PM

[silverking8:]

I am sorry but the 13% yield, are all qualified divideds. There are no cap gain in that number.

2007 May 27 11:38 AM

[QVM Group:]

SilverKing:

According to the ADVDX quarterly fund fact sheet, the "dividend yield" is high as you say. Apparently the Morningstar portfolio statistics report on which I relied is incorrect, or at least in disagreement with the fund publications.

I don't wish to be diverted, however, from my point which is that dividend investing does not create a disadvantage. My article was comparing stocks within the S&P 500 and not comparing yields of dividend oriented funds.

ADVDX may or may not be an interesting investment for some investors, but it is not comparable in approach or profile to the DVY and SDY funds which I mentioned as general proxies for the analysis of dividend bands within the S&P 500.

From its prospectus: ADVDX invests in domestic and foreign stocks. It invests in preferred and common stocks. It invests in convertible bonds. It is invests in turnaround stocks.

The two ETFs I mentioned invest only in domestic stocks of large or medium cap size -- no foreign stocks, no preferred stocks, no convertible bonds and they do not target turnaround stocks, which are probably minimally represented.

ADVDX to DVY or SDY is "apples to oranges" and not a particularly useful comparison.

I have no opinion as to the quality or utility of ADVDX, but I am certain that it is not a relevant consideration in the thesis of my article nor is it an appropriate comparator to DVY or SDY.

2007 May 27 01:14 PM

[silverking8:]

Apples to oranges maybe but M* uses the S&P in the snap shot view for ADVDX .
Thank you for the reply.

2007 May 28 12:16 PM