There is no free lunch in investing! These words ring true, on
average, over time for most investors. After all, investing is a
trade off between growth and price as well as risk and return. The
higher the expected future growth of a stock, the more likely it
will be that investors have to pay a higher price (P/E) to get a
piece of that future growth.
Consider Amazon (
) with year-over-year revenue growth of about 29%. Clearly, it is a
great growth story, and it can be all yours … if you're willing to
pay a P/E ratio of about 100. High expectations for future growth
are already priced into this stock, and the risk of disappointment
if growth targets are not met is high. The opposite exists with
), which clearly has a struggling business with year-over-year
revenue most recently down 4.5%. There is no growth here, but at
four times earnings, much of the known future weakness is priced
in. That's the trade off.
Let me be clear, I am not recommending either stock. Rather, the
point - to repeat myself - is that there is a trade off. While
there are always some rare exceptions to the rule, generally,
investing offers no free lunch. Notwithstanding a couple of recent
studies that focus on relatively narrow time periods, you rarely
get higher returns for lower risk. The pursuit of higher returns
usually involves higher risk.
So, what about dividends? Is a free lunch available? In the last
few years, dividend focused or dividend weighted ETFs have grown
dramatically in availability, methodology and use. Speaking
broadly, many of these strategies have done quite well versus their
broad market cap weighted benchmarks both since inception and over
trailing 3- and 5-year periods. The last 12 months, however, have
been a bit more challenging. The table below compares the returns
of some dividend focused ETFs to their market cap-weighted
(click to enlarge)
Dividend focused ETFs were very en vogue over the last two
years, and it's not hard to see why when we look at the income
producing investment options that investors are faced with today.
Earning a positive real return in this low rate environment is
virtually impossible without some level of risk. It is only natural
that people start looking for other options such as dividend paying
stocks or credit instruments in part of their portfolio. As such,
demand for these products has been strong.
Dividend ETFs' own popularity of the past few years may have set
them up for weakness this year for no other reason than they have
been bid up in the market. Consider the two sectors that are
overweighted dramatically in domestic dividend ETFs: utilities and
consumer staples. These sectors, which traditionally have lower
volatility and lower growth rates than the market, are now more
expensive than the overall market. The Consumer Staples Select
Sector SPDR (
) is sporting a P/E ratio of 18.4, and the Utilities Select Sector
) clocks in with a P/E of 16.4. The S&P 500 itself, as
represented by SPDR S&P 500 (
), is only trading at about 14.8.
Don't mistake the message here. Some dividend ETFs look fairly
attractive from a valuation perspective, especially the
international and emerging market products (see table below). The
domestically focused ones, however, may have simply run a bit too
far too fast. They aren't bad products. They are just no longer
cheap relative to the market because demand bid up the price you
have to pay for the exposure.
(click to enlarge)
All investing strategies come in and out of favor, and investors
pursuing dividend products should treat dividend ETFs as they would
any other investment. First, look at sector and country exposures.
iShares DJ Select Dividend (DVY) suffered handily during the
financial crisis because it had a heavy weighting to financials.
SPDR S&P International Dividend (DWX), after its index was
reconstituted in July, has almost 16% of its exposure in Spain.
Next, look at valuations, volatility, liquidity, methodology and
fees among other things.
Dividend ETFs have many benefits including enhanced portfolio
yield and lower volatility (usually). Further, the 2001 paper,
Does Dividend Policy Foretell Earnings Growth
(Arnott and Asness), suggests that there is a value to holding
dividend paying securities above and beyond just the dividend
These are all nice features in a diversified investment,
especially for those looking to boost portfolio income. That
income, though, should be viewed as a nice snack that may
incrementally improve the portfolio as a whole. Investors in these
products should not expect a free lunch of higher returns and lower
volatility with a significant degree of predictability.
I am long [[DLN]], [[HPQ]]. I wrote this article myself, and it
expresses my own opinions. I am not receiving compensation for it.
I have no business relationship with any company whose stock is
mentioned in this article.
Costamare: Strong Yield In A Low-Rate