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Investors Business Daily
Investors Business Daily

Why Dividend Stocks Aren't 'Free Money'

Investors are looking at dividend stocks almost as if they were ATM machines. But research suggests that income from dividend ETFs isn't free money.

Companies promptly and severely cut dividend payments this year following the Covid-19 outbreak. Some companies are raising dividends again now. But companies' readiness to cut dividends so rapidly is a big warning to long-term investors, says Wes Crill, vice president and senior researcher at asset manager Dimensional (with $527 billion in assets).

"Many investors view dividend payouts as a reliable source of income," he said. "However, those expecting to receive consistent dividend income may have been surprised to see lower-than-expected dividend payouts following the onset of the coronavirus pandemic, when both market volatility and market declines were extraordinary."

Crill found that 38% of global firms (2,584) that expected to pay dividends in the second quarter had cut, halted or eliminated them instead. And in the third quarter, a higher number of companies, 2,699, had done so, Crill says. It gets worse. Companies tend to cut dividends right when investors need income most, such as in a recession or a pandemic.

"One of the issues with extracting that income from dividend-paying stocks is that that dividend is subject to change. And I think 2020 was a great example of that," he said.

Rush For Dividend Stocks Is On

Dividend investors' memories appear short, though. The nearly $31-billion-in-assets Vanguard High Dividend Yield ETF, the largest high-dividend U.S. ETF, is up 15.8% since the start of November through Dec. 9. That edges out the 12.3% gain during that time by the SPDR S&P 500.

Investors see yield. The Vanguard High Dividend Yield ETF sports a dividend yield of 3.1%. That's twice the S&P 500's 1.5% yield.

But don't let the monthlong shift into high-dividend stocks erase memories of the hazards of chasing dividends. High-dividend ETFs have been a disaster.

Even with the recent rally, all five of the largest high-dividend ETFs by assets have lagged the S&P 500 this year. And many by a large margin. The Vanguard High Dividend ETF is down 1.7% this year, even after the rally of the past 30 days. The S&P 500, on the other hand, is up 14% this year. The nearly $15-billion-in-assets iShares Select Dividend ETF yields an impressive 3.8%. But it's also down in price by nearly 8% this year.

The longer term isn't any better for dividend stocks. The Vanguard High Dividend Yield ETF is up just 37.5% in the past five years. That's roughly half the 78% gain of the SPDR S&P 500 ETF Trust.

If yield isn't what matters most, what does? Instead of dividend stocks, investors should target more durable indicators of long-term value, says Crill. And that's a firm's size, relative price and profitability, he says. Additionally, capital appreciation matters more than dividends.

Another Look At Value With Dividend Stocks

Some investors look at dividends as an earmark of value. But that approach leaves investors vulnerable long-term. And a focus on dividends doesn't result in higher returns. Dimensional finds average long-term returns on dividend-paying stocks and dividendless ones are "very similar," Crill says.

Instead of outperforming with dividends, smaller firms and those with lower valuations tend to deliver market-beating long-term returns, he says. The IFA U.S. Small Value Index gained 12.2% a year on average since 1928, topping the 9.97% average annual return of the S&P 500 during that time. And since November kicked off, the Vanguard Small-Cap Value ETF is up 23.1%. And that's despite also having an S&P 500-beating yield of 2.0%.

Dimensional, too, is getting into the ETF game. It's focusing on factors it says drive long-term value.

It launched the Dimensional US Core Equity Market ETF on Nov. 17. It tilts toward smaller profitable companies with lower valuations based on price-to-cash-flow ratios. Most of its top holdings, though, are large technology stocks like Apple, Microsoft and Apple and Microsoft are on Leaderboard. Amazon is on the IBD 50. One thing that isn't a focus, though, is dividend stocks.

"Investment strategies that focus on income derived from dividends may not serve investors who need a steady income stream and, moreover, might not be the most effective way to pursue long-term wealth growth,"  Crill said.

Large Dividend ETFs Have Mostly Beaten The S&P 500 Since November

ETF Symbol YTD % change % change since Nov. 1 Yield Assets (in billions)
Vanguard High Dividend Yield -1.7% 15.8% 3.1% $30.9
SPDR S&P Dividend -0.6% 15.7% 2.6 17
Schwab U.S. Dividend Equity 12.5% 17.4% 2.9 16
iShares Select Dividend -7.9% 17.2% 3.8 14.7
First Trust Value Line Dividend -2.5% 11.8% 2.4 10
SPDR S&P 500 ETF Trust 14.0% 12.3% 1.5 322
Source: IBD, S&P Global Market Intelligence,

Follow Matt Krantz on Twitter @mattkrantz

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