The dangers of dividend-paying stocks

Image courtesy www.lumaxart.com

The current low-interest-rate environment has caused many investors to search for sources of incremental yield. Two of the more popular approaches involve dividends: stocks with high dividends (or higher yields than available from safe fixed income investments) and stocks with fast-growing dividends. We will examine two of these alternatives to see if they're good choices.

High-dividend stocks

To represent high-dividend stocks, we'll use the SPDR S&P Dividend ETF (SDY). This ETF tries to match the total return performance of a dividend-stock index, the S&P High Yield Dividend Aristocrats Index.

While the current dividend yield of the S&P 500 Index is about 2 percent, the yield on SDY is about 3.2 percent. So, that's the attraction, but is it the best way to achieve the goal? We'll analyze the fund using a three-factor regression, which means analyzing the fund's exposure to three major risk factors:

We find that SDY is really a less-diversified, large-cap value strategy, holding just 61 128 stocks. You can see the value orientation in the table below (which covers the period May 2006 [fund inception] to December 2011) -- the fund has a high "loading" of 0.6 on the value factor, meaning it has more exposure (almost twice) to the value factor than does the Russell 1000 Value Index.

The fund's high exposure (0.66) to market risk and (when compared with the Russell 1000 Value Index) value risk, clearly shows that an investment in SDY isn't much more than a value-oriented equity strategy. For those seeking exposure to the value factor there are more efficient ways to accomplish this objective.

Fast-growing dividend strategy

To represent fast-growing-dividend stocks, we'll use the Vanguard Dividend Appreciation ETF (VIG). This ETF seeks to track the performance of the Dividend Achievers Select Index, which consists of common stocks of companies that have a record of increasing dividends over time. The current dividend yield is about 2.1 percent. When looking closer at this fund, we find that VIG looks like a less diversified S&P 500 fund, holding just 144 61 stocks. The fund has the exact same exposure to the size and value factors as does the S&P 500 Index, although it has a lower exposure to beta, or market, risk.

Why these aren't good substitute strategies

In both cases, the funds had significant exposure to market risk, which makes total sense since they're both baskets of stocks. This means they have entirely different risks than bonds, which are meant to be safe havens during difficult market periods.

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Although the dividends from these two strategies may provide higher yields than bonds in this current environment, keep in mind what would likely happen if the market heads south again. Not only would the value of the stocks drop, but the companies may choose to trim or even eliminate their dividends. Certainly, that's what we saw in 2008, as SDY's net asset value dropped 23 percent and VIG's NAV fell 26 percent.

At least you now have the facts, and hopefully a better understanding of the nature of these strategies and the risks they entail. Informed investors generally make better decisions.

Image courtesy of www.lumaxart.com.

[yourPFpro]

So it sounds like your recommendation is to not invest in these dividend funds, as the return/risk ratio is not worth it when compared to the S&P Index type funds?

I understand this type of thinking, but I am wondering about using dividend stocks as a source of passive income. It seems to me that it is a relatively safe investment in this way, if I am not worried about the value of the stock itself. What do you think? Just thinking about other options besides my 1% CD's :)

[LarryswedroeCBS]

The "safety" of dividends is just an illusion. Many dividend paying stocks cut dividends and some even go bankrupt, even safe utilities like PG&E. And just think if the prior recession had turned into a depression then how much do you think you could have counted on the dividends being paid? Imagine what happened to those who invested in dividend paying stocks in the 30s.

Dividends are not a substitute for safe fixed income, in any way, shape or form.

Best wishes
Larry

[Rick Ferri]

The rush to high dividend paying mutual funds and ETFs has another serious drawback starting in 2013 - much higher taxes. Unless Congress changes tax law before 2013, all stock dividends will be taxed as ordinary income rather than the lower prefered rate, plus and extra 3.8% Medicare tax for couples earning more than 250k (singles (200k). This tax increase on an increase is on top of lower deductions, which takes the total tax rate on dividends for some people from 15% up to 44%, and that's before state income tax.