Avoiding The Equity Income 'Dividend Trap'

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Includes: SPHD
by: Invesco PowerShares

Summary

Certain dividend-paying stocks may have many benefits, but may also subject investors to “dividend traps” that overstate future dividend yields.

Investors’ attempts to avoid volatile issuers and “dividend traps” may result in low-yielding holdings.

A multi-factor investment strategy that combines high income and low volatility screens could potentially help investors avoid the risk of “dividend traps”.

Investors should be wary of dividend stocks offering yields that aren't sustainable over the long term

By Thomas Boccellari

Income-oriented stocks can provide investors with numerous advantages - including the potential for high recurring income, a possible inflation hedge and added portfolio diversification. And while diversification does not ensure a profit or protect again loss, dividend stocks can serve as a significant source of investment returns. In fact, over the past two decades, dividends have contributed more than 40% to S&P 500 Index investors' total returns.1

In today's low interest rate environment, investors are seeking yield anywhere they can, and high-yielding dividend stocks may seem like an ideal solution. But these same investors may inadvertently be wandering into a "dividend trap."

Beware "dividend traps"

A dividend becomes a trap when investors are lured by high dividend yields that are misleading or not sustainable. For example, a company's stock price may be in decline because of financial struggles, which may cause a company's management to rethink future dividend payments. Dividends are often paid out quarterly, however, and unsuspecting investors can be trapped by taking a position in the stock before the dividend has actually been cut.

The following chart illustrates one such scenario. Note that this Company A's dividend remains robust for more than a year after the company's stock price begins falling. During this time, investors lured by the promise of high yields may buy the company's stock, only to see the dividend slashed.

"Dividend trap" #1: High dividend and falling share price

Source: Bloomberg L.P., Feb. 29, 2016. For Illustrative Purposes Only. Past performance is no guarantee of future results.

Dividend yields may also appear attractive because the company's stock price is falling - not because of increased dividend payouts. Dividend yields are calculated as a percentage of a company's stock price. Thus, when the denominator (stock price) is falling, dividend yields can be artificially inflated. Falling stock prices rarely bode well for future dividends. By taking a position in a volatile issuer with a declining share price, investors may be entering a "dividend trap".

In the chart below, note that the dividend yield mirrors Company B's falling stock price - rising as the company's share price declines. Note also that the stock's dividend yield is at its peak just before the company slashes its dividend by 80%, before eliminating it altogether.

"Dividend trap" #2: Dividend yield peaking before dividend cut

Source: Bloomberg L.P., Feb. 29, 2016. For Illustrative Purposes Only. Past performance is no guarantee of future results.

Avoiding "dividend traps"

In order to avoid "dividend traps," investors may opt for dividend-grower stocks. These are dividend-paying stocks whose issuers have a history of increasing dividends on a regular basis. Even with rising dividends, however, dividend-grower yields aren't always especially attractive - particularly in a low-yield environment in which the Barclays US Aggregate Bond Index is yielding less than 2.5%. 1

Fortunately, we believe there is one way to reduce the possibility of "dividend traps" without sacrificing yield potential - the addition of a low volatility screen. By using a low volatility screen, investors may be able to generate high current income while avoiding "dividend traps" that can sink an investor's portfolio. The chart below shows the 12-month dividend yield and three-year annualized volatility for a variety of dividend strategies. Over this three-year period, the high dividend, low volatility strategy has generated high current income while reducing volatility relative to other dividend strategies and the S&P 500 Index.

Equity dividend strategies compared: Feb. 28, 2013 - Feb. 29, 2016

Source: Bloomberg L.P., as of Feb. 29, 2016. Past performance is no guarantee of future results. High Dividend Low Vol, High Dividend Grower, Dividend Grower and S&P 500 are represented by the S&P 500 Low Volatility High Dividend Index, S&P 500 High Yield Dividend Aristocrats Index, S&P 500 Dividend Aristocrats Index and S&P 500 Index, respectively. Volatility is represented by standard deviation of monthly total returns.

The PowerShares S&P 500 High Dividend Low Volatility Portfolio ETF (NYSEARCA:SPHD) is a multi-factor strategy whose underlying index screens for high-yielding securities while also making use of a low volatility screen. SPHD provides access to 50 S&P 500 Index holdings that historically have provided high dividend yields with lower volatility. The result is an exchange-traded fund with high yield potential and reduced risk of high volatility and "dividend traps."

Learn more about the PowerShares S&P 500 High Dividend Low Volatility Portfolio.

Source

  1. Bloomberg, L.P., Feb. 29, 2016. Past performance is no guarantee of future results. There can be no guarantee or assurance that companies will declare dividends in the future or that if declared, they will remain at current levels or increase over time.

Important information

Effective Sept. 25, 2015, the Fund's name changed from PowerShares S&P 500 High Dividend Portfolio to PowerShares S&P 500 High Dividend Low Volatility Portfolio.

The Barclays US Aggregate Bond Index is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.

The S&P 500® Low Volatility High Dividend Index consists of 50 securities traded on the S&P 500® Index that historically have provided high dividend yields and low volatility. An investment cannot be made into an index.

The S&P 500® Dividend Aristocrats Index tracks the performance of 40 companies in the S&P 500®

Index that have had an increase in dividends for 25 consecutive years.

The S&P 500® High Yield Dividend Aristocrats Index is designed to measure the performance of companies within the S&P Composite 1500 Index that have followed a managed-dividends policy of consistently increasing dividends every year for at least 20 years.

Standard deviation measures a portfolio's range of total returns and identifies the spread of a portfolio's short-term fluctuations.

There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The Fund's return may not match the return of the Underlying Index. The Fund is subject to certain other risks. Please see the current prospectus for more information regarding the risk associated with an investment in the Fund.

Investments focused in a particular industry or sector are subject to greater risk, and are more greatly impacted by market volatility, than more diversified investments.

Securities that pay high dividends as a group can fall out of favor with the market, causing such companies to underperform companies that do not pay high dividends.

The Fund is non-diversified and may experience greater volatility than a more diversified investment.

There is no assurance that the Fund will provide low volatility.

Standard & Poor's® and S&P® are registered trademarks of Standard & Poor's Financial Services LLC ("Standard & Poor's") and have been licensed for use by the Adviser. The Fund is not sponsored, endorsed, sold or promoted by Standard & Poor's or its Affiliates, and Standard & Poor's and its Affiliates make no representation, warranty or condition regarding the advisability of buying, selling or holding shares of the Fund.

Beta is a measure of risk representing how a security is expected to respond to general market movements. Smart Beta represents an alternative and selection index based methodology that seeks to outperform a benchmark or reduce portfolio risk, or both. Smart beta funds may underperform cap-weighted benchmarks and increase portfolio risk.

Before investing, investors should carefully read the prospectus/summary prospectus and carefully consider the investment objectives, risks, charges and expenses. For this and more complete information about the Funds visit invescopowershares.com for prospectus/summary prospectus.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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All data provided by Invesco unless otherwise noted.

Invesco Distributors, Inc. is the US distributor for Invesco Ltd.'s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. Each entity is an indirect, wholly owned subsidiary of Invesco Ltd. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC, investment adviser. Invesco PowerShares Capital Management LLC (Invesco PowerShares) and Invesco Distributors, Inc., ETF distributor, are indirect, wholly owned subsidiaries of Invesco Ltd.

©2016 Invesco Ltd. All rights reserved.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article was posted on the Invesco PowerShares' blog by an Invesco PowerShares' employee on April 1, 2016: http://www.blog.invesco.us.com/avoiding-equity-income-dividend-trap

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