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Why Dividend-Paying Stocks are Riskier than You Think

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As advisors shift allocations from bonds to high-dividend stocks, they are exposing their clients to equity market risk. But they are also increasing interest-rate risk. Investors in two of the biggest dividend ETFs – SDY and VIG – are among the most exposed to the surging demand for dividend-paying stocks.

Whether or not you think the Federal Reserve has done a good job of managing monetary policy, we likely all agree that it has been very successful in driving down interest rates, and keeping them down for far longer than anyone forecasted (including members of the Fed itself).

Unfortunately, while helping the economy recover, the Fed’s actions have negatively impacted senior citizens who often depend heavily on interest income and savers in general. For them, safe fixed-income investments no longer generate the interest income needed to meet expenses. This is causing many to search for greater yields.

Seeking incremental yield means taking on greater risks – risks that are inappropriate for fixed-income assets whose main role is to dampen the overall portfolio risk to an acceptable level. All the typical strategies investors pursue in their search for yield have the potential to do serious damage. One such strategy is to invest in stocks that pay relatively high dividends. Moving assets from safe bonds to equities obviously involves incremental risk. However, today’s investors are unwittingly taking on an additional type of risk – exposure to rising interest rates. This may be surprising because it goes against what classical financial theory has to say on the subject.

I’ll begin my discussion on the risks of owning dividend-paying stocks versus safe bonds by reviewing the traditional financial view on dividends. I’ll then review some recent research that explains why dividend-based investors are exposed to hidden risks. Lastly, I’ll show that some high-dividend ETFs are particularly vulnerable.

Does dividend policy impact expected returns?

Since the 1961 publication of the paper “Dividend Policy, Growth, and the Valuation of Shares” by Franco Modigliani and Merton Miller, it has been accepted that a firm’s dividend policy is irrelevant to expected returns because investors can transform income to capital gain and vice versa with no or minimal costs according to their own preferences. They can do so by creating “homemade” dividends through realizing capital gains (i.e., selling shares).

The ability to create a self-made dividend was illustrated by legendary investor Warren Buffett in September 2011. After he announced a share buyback program for Berkshire, some market observers went after Buffett for not offering a cash dividend. In his shareholder letter, he explained why he believed the share buyback was in the best interest of shareholders. He also explained that any shareholder who preferred cash could effectively create dividends by selling shares.

There’s another advantage of homemade dividends – they’re more tax efficient than a “forced” dividend paid by a company. Taxes are only paid if you realize the gain, which you aren’t forced to do, and they are due only on the portion of proceeds that are the gain, not on the full amount, as is the case with a dividend.

As such, it follows that dividends should not be an explanatory factor in stock returns.

The explanatory power of dividends

Our understanding of stock returns was advanced further with the 1992 publication of Eugene Fama and Kenneth French’s paper, “The Cross-Section of Stock Returns.” Fama and French’s paper introduced the workhorse asset pricing model in finance, becoming what is generally referred to as the Fama-French three-factor model (the three factors are beta, size and value). In 1997, momentum was added and it became a four-factor model. That version of the model explains over 90% of the variability in returns of diversified portfolios.

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