It seems that some dividend funds can keep up with the market, but this does not mean that they are the best choice. We also need to make sure we factor in both risk and return.
The debate about whether paying out higher dividends is good or bad for investors has been going on for quite a while now, even though this has become a bigger topic lately. It’s not hard to imagine how this could ever be a good thing, with all things being equal that is, it is clearly preferable for a company not to ever pay out dividends, but we don’t necessarily want to just throw out higher dividend stocks on this basis either, as we should want to see how they really stack up first.
Over the long run, if we compare high-flying growth stocks to your average high dividend stock, the high dividend stock won’t present much of a challenge. The fact that we’re picking our stocks based upon growth potential is going to skew the comparison very much in favor of the high growth stocks, and it’s not surprising that they will pretty much beat all comers, regardless of the percentage of dividend paid out.
If we instead make the game fairer for the high dividend stocks and choose the overall market as their competition, the S&P 500 for instance, and pick a good combination of dividend stocks, things get much closer.
This might seem like we’re changing the rules to favor the dividend funds just to prop them up, but for the majority of investors, this is a valid comparison. Most these decisions come down to how a fund compares to the market, how it stacks up to the index funds that 4 out of 5 funds overall get beat by. If you can keep up with the market, this puts you well in the conversation with these folks.
Whether we should set the market as the reference point here and especially be satisfied with market returns just because they are market returns is another matter entirely though, as it turns out.
It is too much to expect a dividend fund to be able to keep up with a growth fund over the long haul, unless we are in a long bear market, because the growth fund is selecting based upon growth and a dividend fund picks their stocks based upon the size of their dividends, and just from knowing this we know that they will not be able to compete.
It may come down to whether someone wants to go with a high dividend fund or an index fund though, and it might even be that the high dividend fund may be seen as preferable, all things considered.
The first thing to realize is that there’s nothing special or magical about getting part of your returns from dividends even though that’s surely not how many investors see things. In the end, part of your return will be from growth and part from dividends, and aside from a dollar in dividends being worth the same amount as a dollar earned from growth, dividend income is less tax efficient, so we should actually prefer growth income over dividend income at least slightly on this basis.
This is just one component and one that we’ll set aside here even though this is going to require that we do a little better with stocks that pay higher dividends to allow us to achieve a little extra return to compensate us for the higher amount of tax we will pay along the way. Mutual funds suffer from the same criticism as well for the same reasons.
We certainly need to set aside the irrational bias that people have in favor of dividends though, somehow thinking that dividend income counts for more, because this is clearly incorrect.
Growth Funds Grow More Because That’s What They Seek
With a growth fund, we’re out for stocks with a high alpha, meaning the tendency to move more than the market in either direction. We like the fact that they grow faster than the market when they grow, but may not like the fact that high alpha stocks tend to go down more as well, which is a particular issue for those who want to hang on to their positions during the times and ride out the storms.
Ultimately, due to the upward bias of stocks, high growth stocks come out ahead in the end, as the higher alpha plays out more to the upside than the downside over time. If you double your gain 3 out of 4 times and double your loss 1 out of 4, this higher volatility is in our favor.
We shouldn’t be concerning ourselves with drawdowns too much if we’re in it for the long haul, like what happened late last year for instance, as if we’re going to stay anyway we need to worry about where we end up because this always matters, and what matters do not include drawdowns that do not have a material effect on us.
If we are timing our positions, we’re not worried about this so much because when we do get the drawdowns, we can manage them to our satisfaction, defining whatever risk we’re comfortable with and stepping aside when we exceed this. This allows us to enjoy the high alpha growth and stick around for that without being compelled to stick around too when times turn bad and we get exposed to the side of this bigger blade that is facing toward us.
That’s not how most people invest, and really prefer to ride things out, but many investors worry way too much about modest pullbacks like this even though they may not be serious at all about timing things. This becomes a moot point but one that can create far more anxiety than warranted.
Regardless, from a risk management perspective, if we can achieve similar returns to the market but reduce the risk, that will impress some people to be sure. Mark Hulbert of Hulbert Ratings, a paid service that ranks investment newsletters, is touting the Vanguard Dividend Appreciation Index Fund ETF, and its lower volatility relative to the market is the main reason.
In his article on this, Hulbert does start out by referencing a 2003 study by Asness and Arnott which claims to show that high dividend stocks produce higher growth over time versus lower dividend ones, which is simply not applicable to today’s reality.
Asness and Arnott looked at company data between 1871 and 2001 and found, not surprisingly actually, that companies that paid higher dividends over this period had higher earnings growth on average. If we stop thinking at this point, we might even think that this means that we can use this today to seek out higher earnings growth.
The flaw isn’t even about going all the way back to 1871 to get our data, although we need to be careful that our data is not so crusty as to be rendered irrelevant or just downright no longer true.
This does confine itself to business results so this one might seem to sidestep that criticism, if not for one thing. High earnings and low dividends are a new phenomenon really, and if we focus on a time where this wasn’t happening, and dividends and earnings were proportionate, of course the ones with higher dividends are going to have more growth. This sure isn’t the case anymore though.
Dividend payments by companies does go back to the dawn of stocks, and how much of a dividend that they paid out has historically been very well correlated with higher earnings growth. You made more and you paid more, and if you paid more this boded well for the future. Nowadays though, many companies look to drive growth more by using this money to drive either their business results or their stock price, and we’ve disconnected this correlation now.
Hulbert invites us to view how this has played out in more recent times, and uses this Vanguard fund to illustrate that it at least keeps up with the market, coming very close to matching the S&P 500’s average return over the past few years. However, this thesis should have high dividend funds beating high growth funds, not just the market, because these high dividend funds should beat everything else out there actually if this view was still valid.
How This Top Dividend Fund Fares Against a Top Fund Period
What we need to do instead is to pit this top high dividend ETF against a top growth fund, such as the ProShares Ultra Pro QQQ. These are stocks picked specifically for growth, and growth correlates with growth as it turns out, even though dividends do not anymore.
The ProShares ETF doesn’t just beat the dividend fund, it simply crushes it. You can pick any time frame you want actually to see this, but for instance, since January 2016, the Vanguard fund is up 65%, where the ProShares one is up 510%.
The objection that dividend lovers would have with this is that growth funds are a lot more volatile, and funds that go up this much also go down a lot as well. During the pullback of late 2018, the chart the ProShares QQQ looked like 2008 all over again as it gave back 50% in less than 3 months, and that might seem scary to a lot of people.
What happens with high alpha stocks is that they go down more than your average stock because people time these stocks a lot more, and the reason why high dividend stocks go down a little less than average is that these stocks tend to be timed less. Timing here means that when we see a pullback, people will get out, mostly to take their profits.
When you are up a lot like you tend to be with growth funds, there’s both more profit to take and more reason to take it, with the expectation that it will sell off more and you will be drawn down more if you don’t act. This might seem to indicate that growth funds are only suited to investors who hold their positions on a short leash and may seem especially unsuitable for buy and hold investors, but this is for the most part an illusion.
This may be a bad choice if you are looking to sell fairly soon, like in the next year or two, and you are in a bear market, but if we actually do have the time to ride these things out, a good growth fund will be way ahead of the curve in the end.
You could take any point in time from 2016 until now, including the 50% drawdown late last year with the growth fund versus the only 20% that the S&P went down and the 16% this dividend fund dipped, and this would still leave you way ahead with the growth fund at the worst of it. Sure, you gave back 34% more during this quarter with the growth fund, but the growth fund had such a big lead at this point that it could have stayed down there since and the dividend fund would still be very embarrassed.
If people limit themselves to either an index fund or a dividend fund, the right dividend fund like this can at least be competitive, although we need to realize that most dividend funds aren’t, and you therefore have to be very selective.
It makes as much sense to say that growth funds beat dividend funds as far as total dividends go as it is to say that dividend funds beat growth funds as far as growth goes, because growth funds don’t seek to maximize dividends, and dividend funds aren’t set up to maximize growth either. Dividend funds can seek both but if dividends are a limiting criterion, this is going to limit growth.
The 10% less volatility that this dividend fund has over the market is also not anything that has much value to investors, even buy and hold ones, the ones that sign up for all the waves that come and look to end up higher in the end. Moves that aren’t traded and therefore have no meaningful impact on your portfolio aren’t going to matter, and the only thing that will is how much you made on the deal.
The same is true with high alpha funds and even with the very high ones like the one we are looking at. The 276% that the S&P has returned since January 2010 may look impressive enough, but when you have gained almost 4800% over this time as this ProShares ETF has, the length of time this fund has been around, the drawdowns don’t even matter because they are so overwhelmed by the sheer massiveness of the advantage.
Like dividend funds, the returns of growth funds do vary and you can end up with dogs with them as well, although your chances of beating the market are higher generally because they are at least trying to do it. The S&P 500 beats them often times, and it is even more important to choose well here, but we want to make sure that we understand the nature of drawdown risk and how this risk plays to our overall strategy.
Many growth funds don’t quite get all this, and they hold back and look to do more diversifying than they should. Perhaps we should call these semi-growth funds, ones that are too shy to give themselves enough of a fighting chance to grow more than a random selection of them. They make the same mistake as so many investors do, even though to a lesser degree.
Investing has to be about looking at both risk and return, and if we are so afraid of risk that we use the combination of grossly overestimating the overall risk of high alpha funds compared to returns, viewing it statically rather than dynamically including returns, and prefer much less potent choices, we are choosing to give up so much for so little.
This is the exact same mistake that bond investors make, being happy to forsake overall results many times larger which could be obtained easily with stock index funds, in exchange for a sense of security based upon confusion. They misunderstand and overrate stock risk in general, just like index fund and dividend fund investors do with the risk of high alpha funds.
Regardless of what and how we choose, we owe it to ourselves to properly consider both risk and return, as if not, we can cheat ourselves very badly, even though in the end we may be none the wiser.