Time and time again, investors argue about the merits of a Dividend vs. Total Return approach to investing, with leading academics on both sides of the argument. On the side for dividends, there is investment titan Benjamin Graham. In his writings, he emphasizes the importance of choosing companies that have a long history of paying dividends. It is hard to argue with Graham, but does his advice back in the 1940s still hold true today?
On the side against dividends (as a metric used for portfolio screening or stock selection) is Eugene Fama and Ken French, who argue that ranking of dividend yield is just another way of screening value stocks. They also argue that among the metrics studied, dividend yield is a poor fundamental to screen. After all, roughly 80% of all listed US stocks do not pay dividends. They also argue that book-to-market or cashflow-to-price are more reliable metrics for finding value, since dividends may be more subject to managerial discretion than other metrics. (source)
Can You Trust Corporate Management?
So where does that leave us? Dividends should not matter, and are a tax inefficient way to provide shareholder value. Pay tax once on corporate profits and again in shareholders' hands. This will be more apparent when the preferential dividend tax treatment expires in 2013. Rationally speaking, you should not want dividends, provided you trust the management.
Therein lies the problem. Graham did not believe that management should be trusted to invest free cash flow. In a 1986 paper in the American Economic Review, Michael Jensen of Harvard Business school showed that free cash flows allow firms' managers to finance low-returning projects that might not be funded by the equity or bond markets. In other words, the market is a more efficient investor for this cash.
The Historical Data
I agree with Jensen and Graham in principle, but I cannot ignore the issue of taxes and costs of dividend-focused strategies (if comparing dividend-focused ETFs from iShares or Wisdomtree to cap-weighted stock ETFs). Also, historical data tends to support Fama and French. For one, as Larry Swedroe shared in this article, a high dividend strategy had a correlation of 0.9 with other value strategies, confirming Fama and French's claim that dividend strategies may just be closet value funds. Swedroe also discovered that the high dividend yield strategy had the lowest Sharpe ratio among the three strategies he studied. The data covered the time period 1952-2009.
Before swearing against dividends, however, it is important to note that high dividends is not the only strategy available to dividend-focused investing. Screening for dividend growth seems to provide more promising results, at least as shown by more recent history. Vanguard's Dividend Appreciation ETF (VIG) had a higher 5-year Sortino rating when compared to the Vanguard High Dividend Yield ETF (VYM) and Vanguard Value ETF (VTV), as shown by Niklashausen's excellent Vanguard ETF 5-Year Scorecard published on Seeking Alpha last month. A nice thing about VIG is that the average dividend yield is no higher than it is for a large cap US stock fund like the SPDR S&P 500 Trust ETF (SPY), so the taxation issue is not as much a concern, though it does have higher turnover which can result in more capital gains distributions.
As can be seen, it is a tough call. I would not replace all of my ETFs with Wisdomtree ETF's (Jeremy Siegel's brand of dividend focused ETFs). On the other hand, carefully chosen ETFs with low costs, low turnover, and good sector diversification (like VIG) can be a replacement for a large cap index fund or ETF, if you sympathize with the ideas of Benjamin Graham and Michael Jensen.