Are High Dividend Stock Funds a Good Alternative?

Dividend funds

Many investors who are disappointed by the low yields on bonds are now eyeing dividends from stocks, including high yield dividend funds. Does this make sense?

There are three main classes of assets, which are categorized as growth, income, and savings. In terms of securities, the growth segment consists of common stocks, the income class contains bonds and preferred stock, and the savings component includes short-term paper, certificates of deposit, and other savings vehicles.

Common stocks are what we normally consider stocks, the ones that go up and down in value a lot, and the goal with them is mostly capital accumulation although they also pay out income by issuing dividend payments to their shareholders.

Preferred stocks, on the other hand, don’t really move very much and provide income to shareholders through dividends. Bonds do move in price but not as much as stocks do, and generally pay out most of their return through interest paid to bondholders. Savings vehicles don’t move much either way if at all and provide the lowest return with the lowest risk of the three categories.

It might seem like higher yield common stocks, the ones that we see in a dividend stock fund, are more like bonds than common stocks, but they are actually purely common stocks that just happen to pay out more of their return in dividends than they do in capital growth. They still pay out most of their return in price appreciation but don’t appreciate in price as much as your average stock and pay out a little more in dividends than your average stock does.

Investment advisors use these categories to help assign investments according to the amount of risk that an investor is willing to take on or is told they should take on, and usually it’s the investor that is told what they should be investing in by these advisors. The more risk tolerant you are, or the more risk that you are told you should be taking on, the higher the percentage of your portfolio you are supposed to have in stocks.

Within the growth category, there are various types of stocks, which we could call high, medium, and low beta, with beta representing how volatile a stock is. High beta stocks move faster than the market does, medium moves around the same as the market, and low beta stocks move more slowly than the market.

Within the income category, there are also gradients of risk, with treasuries being at the low end of the scale and junk bonds and distressed preferred stock being at the other end. Those who are complaining about low yields are the sort that is at the low end of the scale, as there are plenty of bonds that still have good yields, although the risk of their defaulting is also higher.

The normal approach for someone who is a very conservative bond investor and is looking to spice things up a bit would be to look to a bond fund that has the right balance of risk-free treasuries and other bonds that pay more but have a little more risk. We would not expect this type of investor to wish to invest in a high-risk bond fund though as this would be a big step up in risk for them and one that they probably would not be all that happy to take.

Treasuries to Common Stocks is a Big Move Up in Risk Indeed

To suggest that these investors should invest in common stock funds that pay higher dividends than your average common stock is a big move up indeed, into another asset class altogether, moving from the low end of the income class all the way to the growth class.

This is not to suggest that people in this situation not consider this, but if we do choose this, we need to realize that these are not income investments at all and are actually below grade growth investments, with below grade here meaning that their risk to return ratio is below grade.

There are investors who invest in these common stocks for income purposes, and even manage to maintain the mindset that this is their goal, but this is a lot like trying to fit a square peg into a round hole, it just doesn’t match or even make sense that it would. This is the illusion that we need to make sure we don’t have if we’re ready to consider such a move.

Since we’re now moving into the world of common stocks, we also need to see how these investments perform versus the market, both in terms of risk and reward, to make sure that the rewards we give up with these higher dividend stocks are worth it in terms of the benefits that they offer in managing our risk.

The starting point here is to understand what higher dividend common stocks are. With common stocks, a certain percentage is paid out to shareholders in dividends, and the rest is held to benefit the company. High dividend stocks have a better income component because they pay out more to their shareholders each quarter and keep less to benefit the business, whether this is used for expansion, to pay down debt, or to buy back shares.

The higher the percentage of a company’s profits they pay out to shareholders, the less is left to help the business. The more profits they retain, the more they grow their business and their stock in turn.

A good example of this is one company paying out a certain extra amount while another uses it to buy back their shares. Shareholders benefit from both, but with the dividends they get the money in their pocket now and with the buybacks they get it by way of their shares being more valuable than if not for the buy back.

The cash in your pocket is limited to nominal value, while money reinvested in the business, and especially money used to buy back stock, can have the market magnify it, where for instance you put the price of your stock up with a buy back, people see it moving up and jump on and this puts the price up further. Stocks move up over time and this reinvestment creates synergies, which is why this leads to better returns.

Investing in common stocks is all about total return, as these are not income investments and when things get tallied up both capital gains and losses and dividends will be added together to get a total return number. We cannot just look at the dividends and turn away from price considerations or we’re going to be really lost.

When we compare these high dividend stock funds with the overall stock market, we will see that we do give up quite a bit in return but really don’t reduce the risk much at all. This actually serves to make these higher dividend funds a pretty terrible investment overall, and their popularity stems not from good analysis but from illusion.

When the bears come out to play, they swat these higher dividend stocks down with the full force of their paws, and when people are selling stocks, these funds aren’t spared at all, like a utility stock might. We might see a slightly smaller pullback, but the differences here will tend to be quite small and much smaller than the upside we give up to hold them versus just buying the market.

Comparing Dividend Funds with the Overall Market

We’ll take a very popular dividend fund to compare, the Vanguard High Dividend fund, to compare with the market, the S&P 500 that is, which is the benchmark for all stock funds.

During the fourth quarter pullback of 2018, the S&P dropped 20%, while the dividend fund dropped by 19%. Not a big difference there at all. That was only a fairly modest dive, and the last real big one we had was the bear market of 2007-09, a real bear market.

The S&P 500 famously lost 53% from top to bottom, but the drawdown from the Vanguard High Dividend Fund was even greater, coming in at 59%. These aren’t the kind of stocks that are going to shield you from the bears, and given that’s part of the reason why people invest in them, they really need to think again.

If the upside from these dividend funds were as good, we could at least say that they are competitive, but the problem is that since they are paying more out in dividends, this stunts their growth rates and their total return becomes less.

It’s not that these dividend funds don’t move in bull markets, they just move less. Since the 2009 bottom, the S&P 500 has increased by 424%, while the Vanguard High Dividend Fund has only returned 289% over these 10 years. We do need to add in an extra percent per year from the higher dividends, but that still has us below 300% and 125% short of the market. Even if we earned an extra 2%, we’d still be left 115% short.

This also gives us a good idea of how much bigger capital growth is with common stocks than dividend payments, as the market has averaged 42% a year over this time in growth, 10 times more than a high dividend stock pays out in dividends. Even with these stocks, the great majority of the money over the long run will be made with capital gains, so if we’re just looking at their yields, we’re only getting a small portion of the overall picture.

The more recent past tells a similar story. Since the start of 2018, the S&P 500 has returned 9% with all the ups and downs we’ve had since then, but the Vanguard High Dividend Fund has only its higher dividends to show for this as it’s at the same price now as it was then. You are not going to earn 9% more in dividends with this over roughly a year and a half because they don’t even pay that much gross over this time.

We then may wonder why anyone invests in these funds, and the only reasonable conclusion is that they do so without a proper understanding of what they are investing in and especially aren’t aware of the lack of comparative value these funds have to the market.

These funds are collections of below average performing stocks, not in terms of dividends but in terms of overall returns. They aren’t really less risky either. To think that investors who are moving from treasuries to these funds are going to find a good fit is what is really incredible about all this.

These high dividend stocks are real stocks, rock and roll stocks in fact, so if you don’t like rock and roll you have no business in them. They don’t rock as much as your average stock but they do roll in a similar way, so you get all the downside and only about 2/3 of the upside, which makes them even riskier than just going with an index fund because it takes longer to recover from setbacks and you might have to sell when things are down in the doldrums.

These investors would be better off investing in the S&P 500 even though, coming from treasuries, they might be startled at the idea of all that risk. They should be even more startled to realize that this is what they are looking to take on with dividend funds as well.

There’s more to stock and fund selection than just looking at dividends though, as much as we may want to pretend that there isn’t.