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Dividend ETFs are very popular. After all, in a world where money market funds earn nothing, a nice dividend yield sounds great. Dividend and mutual fund ETF portfolio managers are all over the financial media using interviews and ads touting dividend based investing. As a result a whopping $4.8 billion last year went into just three dividend ETFs, the Vanguard Dividend Appreciation ETF, VIG, the iShares High Dividend ETF, HDV, and the Wisdom Tree Total Dividend ETF, DTD.

Despite all the hype, would you believe that all three dividend ETFs are underperforming the overall market? Specifically, over the 12 months from October 5, 2011 through October 5, 2012 the cumulative return on the S&P 500 and the Russell 3000 was 33%. Yet the Wisdom Tree Total Dividend rose 31%, the iShares High Dividend 30% and the Vanguard Dividend was up 27%. In other words, bet you did not know that the three large dividend ETFs underperformed the overall market by between 2% to 6%.

Logic says high dividend paying stocks should outperform in a zero interest rate environment. But logic and reality in the investment world are not necessarily one and the same.

On the other hand, in this increasingly regulated financial environment, portfolios of companies that are using free cash flow to shrink the total number of shares outstanding outperform not only dividend stocks but also the overall market. Float shrink occurs when buybacks are greater than all new share sales.

Float shrink has one obvious advantage over dividends particularly for tax payers. Dividends are currently taxed unless the underlying shares are owned in a retirement type account. And even if dividend tax rates do not go up this year end, dividends are still taxable for most shareholders.

Float shrink is much simpler. Imagine a portfolio of companies shrinking the total number of shares by say 6% for a year while not paying much in dividends. As a result of the float shrink, pre existing shareholders now own a 6% bigger stake in the company without having done anything. And what’s more that float shrink over the past year generated a greater price gain then did high dividend paying stocks as well as the overall market. And that price gain is not taxed until the shares are sold.

Portfolios of companies shrinking the float should outperform even more during bear markets. The Biderman Market Theory defines a bear market as more shares chasing less money. But if companies are shrinking the float in a world where the rest of public companies are selling many more shares then they are buying, then companies shrinking the float obviously should outperform.

Dividends and float shrink are two ways companies can return excess free cash flow to investors. Some promotional type companies try to fake float shrink by borrowing to buy back stocks. But that type of financial engineering usually does not work. Somehow or other the market understands that and those companies stock price suffers for it.

Source: Dividend ETFs Underperform Overall Market While Float Shrink Outperforms All