Akweli Parker: With bonds experiencing an extended period of low yields, investors have been looking to dividend-producing stocks to pick up some of the slack for generating income. So what are the strategies behind these dividend stocks and how do they fit into investors’ portfolios?
Hello, I’m Akweli Parker, and welcome to Vanguard’s Investment Commentary Podcast series.
In this month’s episode, which we’re recording on August 22, 2017, we’ll be talking about dividend-oriented equity strategies. Joining us on the phone from Toronto to shed a little bit of light on this topic we have Todd Schlanger, a senior investment strategist in Vanguard Investment Strategy Group.
Todd, thanks for joining us, and welcome.
Todd Schlanger: Happy to be here.
Akweli Parker: So, Todd, you mentioned two popular dividend strategies in the white paper you coauthored. It’s called An analysis of dividend-oriented equity strategies. Can you talk just at a very high level [about] what those strategies are? And as the conversation progresses, we can dig a little bit deeper into the details.
Todd Schlanger: Yeah. Yes. There’s really two strategies we were analyzing. One is high-dividend-yielding equities. Essentially, these are strategies that invest in equities with higher dividend yields than the broader market that they’re pulled from. The second form would be, really, dividend growth. So these are dividend strategies that invest in companies that have a history of growing their dividend over a long period of time, typically 10 to 25 years.
Akweli Parker: Got it. So if you’re an advisor, or an investor using an advisor, how do you think about these in terms of portfolio construction?
Todd Schlanger: So there’s really two strategies we see used. One would be to try and increase portfolio income. If you look at the secular decline in bond yields we’ve seen, that’s really pushed investors to look for other sources of income, one of which would be the dividend-paying strategies. So when you’re doing that, you’re going to want to think about, are you implementing them as part of the equity sleeve of the portfolio or part of the fixed income sleeve?
When you’re thinking about the fixed income sleeve, you tend to have much higher risk there when you’re doing, let’s say, a substitution, because dividend-paying equities are still equities and they have a much higher risk profile. So we would really think about these strategies as something that could be used as part of the equity sleeve of the portfolio to either increase portfolio income or to get exposure to certain factors that these strategies have had exposure to, whether it be value, low volatility, or quality.
Akweli Parker: If I could jump in here for a second. You mentioned using them as a substitution. Can you explain what you mean by that?
Todd Schlanger: Yeah, so if you’re adding dividend strategies to the portfolio, you’re going to need to essentially put them in a part of the portfolio. You would either allocate to them as part of the equity portfolio, so essentially substituting what’s already there for these strategies, or as part of the fixed income sleeve. But, again, that entails certain risks.
Akweli Parker: Okay, so, Todd, one of the points that you make in the paper that I found really fascinating was that higher dividend yields don’t necessarily equate into higher returns. And you said that dividend-oriented equities are best viewed from a total-return perspective. Can you talk about what you mean by that?
Todd Schlanger: It’s interesting when you think about it, that dividends are different in terms of, let’s say, the interest you would receive from a bond in that they’re not a source of wealth creation. They’re really a distribution of capital. So when a dividend is essentially paid, it’s distributing part of the capital of an equity out to an investor.
Akweli Parker: So the stock itself doesn’t become more valuable?
Todd Schlanger: Exactly. The price of the stock will fall by the same amount of the dividend on the ex-dividend date. So what that means is that if you think about stocks with high dividend yields and stocks with low dividend yields, they shouldn’t really be positively or negatively impacted by the higher or lower dividend. And, actually, if you look over long periods of time, they tend to have pretty similar returns.
Akweli Parker: All right, so what is the appeal, then, of these dividend-oriented equity strategies that you write about?
Todd Schlanger: I would say there’s really two factors. One has been with the secular decline in bond yields we’ve seen. That’s really pushed investors to look for other sources of income, one of which has been dividend-paying equities. The other real driver has been the historical performance. So if you look over the past 20 years, both forms of dividend strategy have actually outperformed the market with less volatility. In other words, they’ve produced higher risk-adjusted returns than the broader markets, and that’s also been of interest to investors.
Akweli Parker: So you talk about performance over this period of time, like the past 20 years. How should investors be thinking about the persistence of these strategies’ performance?
Todd Schlanger: That’s a great point. What’s interesting is, even if you look over the long periods where you’ve seen this outperformance, most of the outperformance came in just one period. So that was really the technology-stock bear market [of] the late ‘90s, early 2000s, when you had this selloff in growth stocks. And these strategies have exposure to more value-type securities, lower-volatility quality-type equities that really outperformed in that period. So you saw very significant outperformance then.
Over most other periods, the performance has been closer to the broader market and also volatile. So there’s been periods when these strategies have outperformed. There’s also been periods when they’ve underperformed.
Akweli Parker: Is there any way of predicting when those periods might happen or do you just need to sit tight for the long term if these are something you’re interested in?
Todd Schlanger: Yeah. Unfortunately, these periods—because every bear market tends to be different and every change in market direction tends to be different—it is very difficult to predict exactly when these strategies will outperform.
For example, if you think about the global financial crisis, these strategies actually underperformed in that period because it was very different in terms of the drivers than what drove the technology-stock bear market.
Akweli Parker: Good to know. You alluded in a previous question that the performance of these strategies can be largely attributed to what we know as factors. So can you just quickly define for us what we mean by factors and maybe get into a little bit more [about] what the main factors are that come into play with these dividend-oriented strategies?
Todd Schlanger: Sure. Factors are really something that started in the academic community. And it was really looking at factors that explain the risk and return of portfolios. To give you an example: value, smaller equities, momentum, low volatility, quality.
If you think about the high-dividend equities, they’ve had exposure to, really, these lower-volatility and value-type equities. If you think about dividend growth, it’s been more this low volatility but also quality. So, they tend to explain, along with the market beta, about 95% of the portfolio’s return in terms of the high-dividend strategy and then about 89% of the portfolio return in terms of dividend growth, so very high explanatory power in terms of what’s actually driving these portfolio returns.
What that really means for an investor is, as you would think about not only the historical performance but more forward-looking expectations, you’re going to want to think about the reason that these factors exist and whether or not the rationale behind that is consistent with something you would want for your portfolio. And there’s different, either risk-based or behavioral explanations for why these factors exist.
Akweli Parker: Got it. With the yield and performance that we’ve been talking about—and you’ve alluded to this as well earlier—about potentially swapping out the fixed income segment of one’s portfolio for dividend-producing equities—I imagine that that might alter the risk equation a bit?
Todd Schlanger: Yeah, so we would really issue caution when thinking about that kind of substitution because dividend-paying equities are still equities. The major driver of the returns is still going to be the performance of the overall equity market. And we know that it’s much more volatile than high-quality investment-grade bonds. We often say that a bear market in fixed income is nothing like a bear market in equities. So if you’re doing that kind of substitution, you’re really going to significantly increase the risk of the portfolio in terms of volatility and also the potential to see a significant drawdown or capital loss.
Akweli Parker: Right. You mentioned in the paper, Todd, that these dividend-oriented equities have greater interest rate sensitivity than other equities and that, therefore, makes them more susceptible to changes in bond yields. Can you talk about how that relationship works?
Todd Schlanger: Yeah, that’s an interesting one because if you think about it, it’s really behavioral in nature. So when, let’s say, interest rates rise, as they recently have in the U.S. and Canada, investors essentially become less yield-hungry because yields of assets are higher. And so what they tend to do is sell higher-yielding assets and that really pushes down the price of these dividend-paying equities.
At the same time, let’s say interest rates fall, that can actually bring about the opposite behavior. That can bring about a buying of these higher-risk assets, which is something we’ve seen, really, since the global financial crisis. And that tends to push their prices up. And so what you see is that in periods of rising interest rates, these types of strategies tend to underperform other equities. At the same time, in periods of falling interest rates, they tend to outperform.
Akweli Parker: That makes sense. Let’s talk about a topic that I know is of interest to many investors, and that is taxes. Can you talk about how dividend income stacks up compared with other types of income, whether it be that you earn on the job, capital gains income, etc.?
Todd Schlanger: Yeah. For any taxable investor, taxes, of course, are going to be critical. If you think about dividend income in places like the U.S. and Canada, it tends to be more tax-efficient than, let’s say, ordinary income or income you would earn on the job.
There’s another form of income, however—capital gains—that can actually be more tax-efficient than even dividend income. So you really need to think about the different types of income you’re receiving and the relative tax treatments. In, let’s say, Australia and New Zealand, for example, you have dividend franking credits, and these are really credits that help make the effective tax rate on dividends lower, so you also see preferential treatment.
So it can really depend on not only the country that the investor is paying taxes in, but also the relative forms of income that they’re receiving.
Akweli Parker: This sounds like something you definitely want to consult an advisor or a tax attorney about.
Todd Schlanger: Exactly. I’m giving general rules of thumb. And of course, based on any investor’s individual circumstance, they’re going to want to consult a proper tax professional when thinking about how these tax treatments apply to them individually.
Akweli Parker: All right, excellent. Well, Todd, we’ve covered a tremendous amount of ground in this conversation. I’ve certainly learned a lot. I hope that our listeners have found this helpful as well. Before we sign off, any final thoughts from you on this topic?
Todd Schlanger: So, I would say a few things. One is keeping in mind that not all dividend strategies are the same. In this podcast, we talked about high-dividend-paying equities and these strategies that have a history of really growing their dividends over a long period of time. In either case, an investor wants to think about not only the dividends that they’re likely to receive from these, but also capital appreciation, because that’s going to make up their total return.
When it comes to implementation, you really need to think about how these strategies are going to fit in a portfolio—whether it’s to increase portfolio income. And in that case, we would really recommend them being used as part of the equity sleeve of the portfolio because they really have much different risk characteristics than high-quality bonds. And when they’re used there, they can really increase the risk profile of the portfolio.
The other way that these strategies are used is, based on their historical record, some investors believe that they’ll deliver better risk-adjusted returns. And if you’re thinking about using them in that way, you really need to think about the cyclicality of performance that comes along with these types of strategies relative to the broader market and, also, the factors that have really attributed to the historical returns we’ve seen. So for the high-income equities, it’s really this low-volatility value exposure. And then for the dividend growth, it’s more this low volatility and quality. So you really want to think through if those are the kinds of exposures you want in the portfolio and whether or not you really have a conviction that they’re going to outperform going forward.
Akweli Parker: Those are some really helpful points, and that sounds like a good note on which to wrap up our talk on dividend-oriented equity strategies.
Todd Schlanger, thanks once again for being with us today.
Todd Schlanger: Thank you.
Akweli Parker: And thank you for joining us for this Vanguard Investment Commentary Podcast. If you’d like to learn more about today’s topic, download Todd’s research report An analysis of dividend-oriented equity strategies from our website, vanguard.com.
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