Is Dividend Investing a Scam?
Why seeking yields is a losing game.
Hello Pulsers,
In this issue of the Market Pulse, I will examine one of the most controversial topics in finance!
Is dividend investing a good strategy? Does it outperform the market, and is it worth the hype?
If you search on Twitter for dividend investing, you will see that hundreds of accounts have amassed millions of followers and advise people to invest in dividend stocks.
I do not have any problems with these accounts personally, but I am searching for an answer to a question: Is dividend investing a wise strategy? Or are you forgoing a lot of returns by investing in dividend names instead?
Let’s look at the numbers.
Dividend ETF V.S. Passive Index
When you look at the numbers and compare some of the favorite dividend-paying ETFs and compare them with the S&P 500, you start to see a pattern.
I compared the high dividend-paying Vanguard ETF, VYM 0.00%↑ , to their really popular S&P 500 ETF, VOO 0.00%↑ , for the past 10 years.
It is also important to note that this chart looks at total return rather than just price return and considers dividend payments and reinvestments.
When you look at the numbers, they are terrifying. The VOO 0.00%↑ return in the last 10 years is 246% V.S. VYM 0.00%↑ ~162%. That is 84% in 10 years!
That means, on average, this portfolio has underperformed the VOO 0.00%↑ portfolio by 6.29% compounded annual return.
So, how big of a hole would it be if your portfolio underperforms a passive index by 6.29% per year?
Here are the numbers after 40 years of investing, assuming you have been investing $6,000 per year.
For simplicity, we assumed the dividend ETF returned 6% per year, and the passive portfolio returned ~6% more, closer to 12%. Of course, these numbers are all made up to illustrate a point.
The return difference is eye-opening. After 40 years, by just contributing $6,000 dollars, your returns are $3.6M more.
But what about other yield products? What about high-yield covered calls ETFs? Do return discrepancies exist in those products as well?
Well, let‘s take a look.
Covered calls ETFs
Here is the performance profile of $JEPI, a covered call ETF actively managed by JP Morgan, compared to the S&P 500 ETF $SPY.
As you can see, JEPI 0.00% underperforms by almost 5%↑ per year compared to $SPY. Now, it is correct that SPY 0.00%↑ is likely not the proper benchmark, as JEPI 0.00%↑ has many individual names that are closer to Dow Jones than to the S&P500, but this underperformance is still there.
Here is the difference between JEPQ 0.00%↑ and QQQ 0.00%↑ , which are identical proxies, except one is writing a covered call on Nasdaq 100, and the other is not.
The underperformance is closer to 10% in just a year and a half. Now imagine what that would look like if this outperformance compounds for 30 years! You would be leaving millions on the table.
But why is dividend investing not an efficient way of investing? In this article, I look at two key reasons:
Tax efficiency
Return on invested capital
Tax efficiency
The first reason is tax efficiency. Ordinary dividends are taxed at a higher rate than long-term capital gains.
Additionally, dividends are a form of capital return to investors. However, dividends are one of the least efficient ways of returning capital to an investor. Nowadays, most companies return capital to investors not through dividends but through share buybacks. Share buybacks are exactly like issuing a dividend, as the company returns capital to the shareholder, but the shareholder does not pay taxes.
The company's earnings per share will increase assuming constant earnings and fewer shares outstanding, and the share buybacks should increase the share price as the company, as the marginal buyer of the shares, is not price sensitive. This is why, when you look at the last 10 years, you will see a clear picture of why more and more companies are issuing share buybacks rather than dividends.
Return on invested capital
When a company returns capital to you, this is the money it could have invested in research and development and hiring talent to fuel more growth and earn a higher return.
When a company pays a dividend, it signals that it does not know a better way to spend this money.
Look at some of the dividend-paying darlings, Pfizer and Johnson and Johnson, compared to the benchmark of XLV 0.00%↑ a healthcare index.
As you can see, both names have massively underperformed the index. JNJ 0.00%↑ and PFE 0.00%↑ both have desirable dividend yields in the dividend investing community.
Pfizer pays a 6.41% annual dividend, while Johnson and Johnson pay a 3.25% annual dividend. Both stocks have heavily underperformed the Healthcare index.
There could be many reasons for this, but a lack of investment in R&D is likely a key contributor to this underperformance.
So, What should an investor do?
Shareholder yield
While dividends are not inherently bad and should be considered in a well-diversified investment portfolio, they are not a way of investing. People who solely focus on dividends will clearly miss many great opportunities in the market.
My problem is with the culture of seeking yields, which will ultimately cost you millions in returns.
If a company pays a large dividend, that dividend comes at a cost to you: future growth potential.
There is no free lunch in the market, and if the company is paying you cash today, that cash comes at a price of future growth.
As an investor, you should look at the total shareholder yield, not the dividend yield. Shareholder yield considers share buybacks and dividends and is a far better measure of the return of capital to the investor.
Last Words
As many of you have seen, most of the charts and analyses I use are from interactive brokers. Interactive Brokers provides some of the best commission structures, yields on idle cash, and, more importantly, one of the best tools for active trading. As an active options trader, I can only imagine myself trading with the tools that they have provided.
If you are still deciding, check out their free simulator and everything else they provide to help you get started.
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Disclaimer
The opinions provided in this newsletter are mine and mine only and do not represent any firm or other affiliation.
You understand that NO content published and discussed during this newsletter constitutes a recommendation that any particular investment, security, portfolio of securities, transaction or investment strategy is suitable for any specific person.
You further understand that I will NOT advise you personally concerning the nature, potential, value or suitability of any particular investment, security, portfolio of securities, transaction, investment strategy or other matter.
This presentation and the content provided are for educational purposes only.