Just as a famous artist can have an influence beyond their chosen genre of art and beyond the arts entirely, the world of finance can see the influence of a particular metric or practice reverberate far beyond its initial purpose. As we look at the world of smart beta as a wave into the future, it makes sense to examine the role that dividend indexes played in popularizing smart beta and note how relevant these still are today.
Dividend indexes are comprised of public companies that pay dividends to shareholders. It was dividend-paying companies that were the focus of the earliest smart beta index funds.
There were good reasons why dividend stocks were a leading driver of early-stage smart beta indexes, and these same factors hold true today. Keeping track of what stocks are paying dividends and how they are positioned in the market is an essential step for getting a handle on equities and making sure you can leverage the market with the highest efficiency. The arguments that propelled dividend stocks into the early stages of smart beta still hold true today:
Companies that distribute dividends tend to be better managed and more stable. Those companies that are in a position to distribute cash payments to its equity owners are typically companies that have reached a certain size and are able to leverage their critical mass and stability in order to take care of its shareholders. If a company is trying to expand rapidly or finds itself in the middle of a reorganization, it will likely not be able to pay dividends. That rapid growth is good, but it comes at the cost of a sharp increase in risk.
Dividends can clue an investor into the very basic value of the company. A stock trading below its value is a valuable one to have in a long-term portfolio, and discerning true value via dividends can help investors ferret out those stocks that may be punching below their weight today but show the promise of great gains in the not-to-distant future. A time-tested method of valuing a stock is the Dividend Discount Model, which uses projected company dividends to calculate what shares are actually worth.
Dividend stocks are a haven from volatility. Investors tend to gravitate to dividend-paying stocks when there is increased volatility in the fixed income markets. But the fixed income market today is not the safe haven it once was, with volatile conditions becoming more commonplace than ever. Not only are rising interest rates making corporate debt more cumbersome for issuers but lower oil prices, slowdown in manufacturing in China and continued Middle Eastern strife all indicate that fixed income volatility will likely not abate this year. This makes dividend stocks one of the safest asset classes in which to park capital.
Long-term investors often prefer them. Because dividend stocks are more stable and often household names with market-dominant positions, they attract long-term investors. These investors are not going to cash out at the first sign of volatility but are holding on to these stocks for the long haul, oftentimes within a retirement portfolio. In other words, you will be in good company.
Dividends account for large portion of market returns. For the ten years ending December 31, 2015, over 40% of the 110% return that the Nasdaq US Large Mid Cap Index experienced was due to dividends. Put another way, almost half of the returns experienced by large and mid-cap US securities over the last ten years were derived from dividends.
All this being the case, it is important not to view dividend stocks as a panacea to all your volatility qualms. There is no perfect investment to hedge against volatility—volatility will always be in the market. Just as any other security, dividend-paying stocks are worth looking at with a skeptical eye, taking into account all the potential drawbacks. Even with all of these caveats in mind, the dividend-paying stock world is still a smart hedge in the face of volatility.
Let’s not look at them as a replacement of a well-diversified portfolio but as a good guide and necessary component of these practices. There’s a reason they have been around so long and continue to be a foundation for new smart beta indexes going forward. In times when financial products are coming onto the market at a faster clip, it pays to look back at the roots of smart beta investing and keep dividend-stock indexes at the top of your mind.
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