Putting too much emphasis on dividend yield can harm the total return of your equity income investment.
A version of this article appeared in the July 2017 issue of Morningstar ETFInvestor. Download a complimentary copy of Morningstar ETFInvestor by visiting the website.
It’s easy to understand the allure of dividend-paying stocks. Dividend payments can help investors manage behavioral issues such as their reluctance to realize capital gains to meet income needs, and may give them the fortitude to weather market volatility.
In the United States, dividend payments are usually stable because management teams are reluctant to cut them, as this may signal a loss of confidence in their company’s prospects. Research also has shown that dividend payments contribute about half of U.S. equities’ long-term returns.
Dividend payments offer investors many benefits, but focusing narrowly on dividend yield can increase risk. This is akin to buying bonds based strictly on yield. As always, it is important to focus on an investment’s prospective total return, and not solely its yield, as higher yields usually imply greater risk.
For example, the highest-yielding stocks could be under financial distress and thus may be more likely to cut their dividend payments than their lower-yielding counterparts. Many high-yielding stocks pay out a large share of their earnings as dividends, leaving a small buffer to cushion these payments if their business deteriorates.
A high dividend yield looks attractive at first blush, but it’s also important to remember that dividend yield is a ratio – the dividend payment (numerator) divided by the stock price (denominator). A company’s dividend yield increases when the dividend payment (numerator) is unchanged, but its stock price (denominator) decreases. Here, I will walk through a couple of examples of high-yielding funds that have narrowly targeted dividend yield and paid the price.
Be Wary of Backward-Looking Metrics
PowerShares High Yield Equity Dividend Achievers ETF PEY targets high-yielding stocks and seeks to reduce its risk by selecting its holdings from U.S. stocks that have raised their dividend for at least 10 consecutive years. From this subset of historical dividend growers, it selects the 50 highest-yielding stocks and weights them by their trailing 12-month yield. The fund’s dividend yield figure has averaged 5.3% over the decade through May 2017, versus 2.3% for the Russell 1000 Index. Although PEY has sported an attractive dividend yield, its total return hasn’t kept up with the Russell 1000 Index since its inception in January 2005. Exhibit 1 shows the total return of $1.00 invested in PEY and the Russell 1000 from January 2005 (PEY’s inception) through May 2017.
Exhibit 1. Growth of $1