Seeking to Enhance Portfolio Returns with a High-Dividend Equity Strategy
The search for higher returns and lower risk has often left many investors vacillating between different investment styles and vehicles. As illustrated in this paper, one strategy, high-dividend equity investing, has demonstrated consistent outperformance with little added risk, meriting an allocation in a wide range of portfolios. This paper examines how an allocation to high-yielding stocks can potentially boost performance and actually lower risk in certain portfolios. It also looks at factors to consider when determining an allocation to high-yielding stocks and stock portfolios.
High-Dividend Equity: Identifiable Traits
A high-dividend equity strategy involves more than amassing a group of stocks that pay dividends. The key is focusing on companies that generate significant free cash flow and have a history of maintaining or increasing their dividends.
“Companies with healthy dividends typically generate significant free cash flow and have communicated their commitment to using this cash to enhance total return for shareholders,” said Walter C. Bean, senior vice president and head of the equity income investment team for Federated Investors. “Historically, many of these companies have been found in income-producing sectors of the market such as utilities, consumer staples, telecommunications services and energy. It is not unusual for high-yielding securities within these sectors to present valuation advantages such as relatively low price/earnings, price/book value and price/cash flow ratios.”
This combination of cash flow and valuation may explain in part why high-dividend equity strategies have offered a positive risk/return differential. “With a substantial portion of the return coming in cash, there has been a significant advantage in terms of achieving better risk-adjusted returns than the overall market,” Bean said.
When examining the benefits of high-dividend equity approaches, the Dow Jones U.S. Select Dividend Index is a useful proxy. To be included within the index, a company must have a non-negative, five-year dividend-per-share growth rate, a five year average dividend-to-earningsper-share ratio of 60% or less and a three-month average daily trading volume of 200,000 shares or more.1 Stocks meeting these criteria are ranked by dividend yield, and the top 100 weighted by dividend yield are selected. History is available back to December 31, 1991, and the index is rebalanced annually in December.
Chart 1 illustrates how the risk/return differential of high-dividend equities and the broader market have played out historically. For the period beginning January 1, 1993, and ending December 31, 2012, a high-dividend equity strategy generated an average annualized total return of 10.81%—260 basis points higher than the 8.22% annualized return realized by the S&P 500.2 At the same time, risk, as measured by standard deviation, was only 27 basis points higher for a high-dividend equity strategy.
The Advantages of Dividend Yield
The outperformance of high-dividend equities stems from several advantages offered by dividends and dividend-paying companies. For one, because a sizeable portion of their return is in cash, dividend-paying stocks may help to cushion a portfolio’s downside when the broader market is posting losses. As Chart 2 indicates, dividend yield has generated an average positive return of 4.45% in the down markets since 1926, which has helped to offset the average negative total return of -14.06% during these periods.3
The ability of dividends to mitigate a portfolio’s downside stems, in part, from their relative stability. Although high-dividend equity portfolios may underperform during strong growth markets, historically, dividend returns have been much more stable than price-only returns, as Chart 3 illustrates. This relative stability is crucial for investors building portfolios to finance retirement, higher education and other long term goals.
In addition to displaying more stability than price-only returns, dividends continue to offer an important tax advantage for many investors— even with the 2013 tax legislation affecting investment income. This legislation assures no additional tax consequences on dividend income for individuals earning under $200,000 per year and households earning under $250,000. For individuals earning $400,000 and above and households earning $450,000 and above, the law lifts the tax rate on dividends (and capital gains) from 15% to 20%.
As part of the 2009 Patient Protection and Affordable Health Care Act, there also is a 3.8% tax on unearned income, including dividends, that applies to individuals earning $200,000 and households earning $250,000 and above, for a total of 18.8%. The total tax for individuals and households earning $400,000 and $450,000 and above, respectively, is 23.8%, well below the rate if dividends were taxed as ordinary income.
Determining High-Dividend Equity Allocations
Many investors understand the benefits of a high-dividend equity strategy but are uncertain about how to allocate their portfolios to capitalize on it. An appropriate allocation depends on an investor’s goals, risk tolerance and time horizon. Although past performance does not guarantee future results, historical returns may shed light on the potential advantages of high-dividend equities within aggressive, moderate and conservative portfolios.
Within each of the hypothetical allocations that follow, highdividend equities enhanced average annual total return and generally reduced volatility.4 There’s a clear message here for investors: High-dividend equities may have appeal that goes beyond occupying a small slice of a conservative portfolio. A high level of reinvested dividends typically cushions a portfolio during down markets and contributes significantly to long-term total return—factors that are important to almost all investors.
High-dividend equities may help aggressive investors deal with one of their most vexing challenges—mitigating the potential downside of a portfolio weighted mostly to stocks. Changing the equity allocation from 80% stocks of the S&P 500 to 40% stocks of the S&P 500 and 40% high-dividend equities improved the annualized total return by 155.3 basis points and reduced risk as the top Aggressive Portfolio illustrates in Chart 4.
As the bottom Aggressive Portfolio illustrates in Chart 4, high-dividend equities may also add value to a portfolio with a sizeable allocation to a more volatile equity class such as small caps. In this case, including high-dividend equities within the stock allocation increased the annualized total return by 97 basis points andreduced risk.
As illustrated in Chart 5, a portfolio crafted for a moderate risk tolerance does not have to settle for middle-of-the-road returns. Allocating 30% of the portfolio to high-dividend equities improved annualized total return by 115 basis points while reducing risk. In this case, the return exceeded both of the aggressive portfolios that did not include high-dividend equities—with a considerably lower standard deviation.
High-dividend equities traditionally have been associated with conservative portfolios designed to pursue growth with reduced risk. Allocating half of the stock portion of a conservative portfolio to high-dividend equities, as Chart 6 illustrates, may help an investor pursue these dual objectives.
Dividend Growth and Inflation
The risk and return associated with the aggressive, moderate and conservative portfolios assume that all dividends are reinvested to enhance total return. But many investors instead rely on cash dividends to supplement other sources of income. When constructing portfolios for these investors, it’s important to consider not only risk and return but also how the portfolio’s potential for income compares with historical trends in inflation.
“Inflation is the enemy of income investors,” noted Federated’s Bean. “There are portfolio managers who create income-oriented portfolios by making them bond like. But the problem with this approach is that there is little likelihood of an increase in the income stream. By investing in stocks with the potential for growth in dividends, the income stream may move higher, which benefits investors who expect their need for income to rise over time.”
Balancing Risk and Return
A high level of dividend income can provide a distinct advantage when fixed-income yields are low, the outlook for inflation is uncertain and the broader equity market is volatile. While a specific allocation depends on individual circumstances, high-dividend equities can be an important part of a wide range of portfolios. With increasing numbers of investors looking to enhance returns while financing retirement, higher education and other long-term goals, interest in high-dividend equity investing is likely to remain strong in the years ahead.
- A sizeable portion of high-dividend equities’ return is in the form of cash. Therefore, dividend-paying stocks may help to cushion a portfolio’s downside when the broader market is posting losses.
- Although high-dividend equity portfolios may underperform during strong growth markets, historically, dividend returns have been much more stable than price-only returns.
- Dividend-paying stocks, when included in hypothetical portfolios of varying investor profiles, help to improve returns while generally lowering overall portfolio risk.
- The key to dividend investing is capturing equities with dividend-growth potential to outpace the effects of inflation.