introduction
What to do Business development company (BDCs) and covered call and preferred income strategies have something in common?
Most obviously, all of them offer dividend yields well above the S&P 500 and are particularly popular with yield-hungry retail investors. What’s less obvious is that each one of those strategies have underperformed the S&P 500 on a complete return basis over the long run. In other words, dividend investors trade capital for income.
Do investors have to just accept lower yields in exchange for top dividend yields? No, they do not. In fact, do-it-yourself high-dividend strategies can generate enviable returns without sacrificing capital.
Strong dividend stock performance
The Global X SuperDividend US Exchange Traded Fund (ETF, DIV) is our proxy for a high dividend US stock portfolio. The ETF has a 10-year track record, manages greater than $600 million in assets and charges 0.45% fees per yr. It consists of fifty equally weighted high-dividend yield US stocks which have consistently paid dividends over the past two years and are less volatile than the US stock market.
The Russell 1000 Value Index serves as a benchmark as a consequence of its portfolio composition and its positive exposure to value aspects, low volatility and size, and its negative exposure to quality. DIV’s dividend yield is 6.3%, in comparison with 2.0% for our Russell 1000 Value Index proxy, the iShares Russell 1000 Value ETF (IWD).
Dividend Yields: US High Dividend ETF vs. Russell 1000 Value
Source: Finominal
However, this comparison shows a compound annual growth rate (CAGR) of two.5% for DIV versus 9.0% for the Russell 1000 Value Index between 2013 and 2023. Although the US stock market, represented by the S&P 500, is just not an acceptable benchmark , but performed even higher at 12.4%.
That DIV achieved virtually no performance over a decade despite its benchmark doubling and the S&P 500 nearly tripling in value is a remarkable achievement.
Performance of high dividend US stocks
Source: Finominal
Dividend yield vs. return on capital
If we break down DIV’s performance into price and dividend yields, we see that capital investment fell from $1,000 in 2013 to $660 in 2023. While DIV has generated positive total returns over the past decade, these have all come from dividends.
This shows a poor stock selection process that distributed capital to struggling firms that also paid high dividends. Such firms could also be overleveraged, have lackluster products, or be in declining industries. In value investing jargon: them are value traps – low-cost for a reason.
Price vs. Dividend Yield: Global X SuperDividend US ETF (DIV)
Source: Finominal
Synthetic dividends over capital gains
What is a dividend?
It is solely a distribution of capital by an organization to its shareholders. Nothing more, nothing less. In theory, all publicly traded firms could return excess money not needed for operations or investments to their shareholders. But many firms – including Amazon – are deciding against it. Other firms have negative operating money flow but still pay dividends because shareholders expect them to. Instead of paying dividends directly, Many US firms have began buying back their shares.
In principle, investors also needs to acquire firms growing money flows quite than specializing in dividends. After all, the dividends an organization pays say little concerning the company’s underlying health.
However, if we hold a stock, mutual fund or ETF, we will generate our own synthetic dividends by selling a portion of our investment. Amazon may not pay dividends, but as investors we will set a desired dividend yield, say 4% per yr, and sell the required percentage of our Amazon investment quarterly to realize that 4%. Through such synthetic dividends, we will increase the dividend yield of the Russell 1000 Value or any index to our desired level.
Increasing dividend yield through return on capital
Source: Finominal
Tax considerations
Of course, switching from unusual to synthetic dividends requires some mental and other adjustments. Because synthetic dividends represent a return on capital quite than a return on capital, they’re only taxed as a capital gain quite than a dividend if the investment was profitable.
While some investors can minimize taxes, akin to through Roth IRAs, for a lot of others, taxes can still significantly reduce the underlying value of the investment. DIV’s total after-tax return from 2013 to 2023 is 13.3%, assuming a dividend tax rate of 20%. This compares to a pre-tax return of 29.7%.
Investors could have synthetically achieved a similarly high dividend yield for IWD. The pre-tax return would have only fallen from 146.0% to 132.9% if we had taken under consideration a capital gains tax of 15%. This is a much higher return than DIV. So what explains the difference? The majority of that is as a consequence of the health of firms within the IWD.
High Dividend Strategies: After-Tax Returns
Source: Finominal
More thoughts
Proponents of traditional dividends might claim that DIV’s poor performance is the results of a poor stock selection process. Other products that prioritized dividend growth over yield may need performed higher. While such an approach could reduce underperformance, it might also reduce the dividend yield. For example, the T. Rowe Price Dividend Growth ETF (TDVG) includes greater than 100 dividend stocks but only offers a 1.3% dividend yield, lower than IWD’s 2%.
The conclusion is obvious. Instead of trying to search out firms that pay dividends without destroying investment capital, it could be higher to take the S&P 500 or one other benchmark and create synthetic dividends with the specified return. In other words, not all financial engineering is bad.
Further insights from Nicolas Rabener and the Finominal Team, enroll for her Research reports.
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Photo credit: ©Getty Images / stevecoleimages
