There’s nothing worse than explaining underperformance to clients.
For better or for worse, investors tend to look at the S&P 500 as a universal benchmark for their portfolio performance, regardless of risk profile. And being anchored on the S&P 500 can create problems in perception, beyond the typical risk and reward conversation that’s all too common between advisor and investor.
To demonstrate this clearly, let’s look at the 30 largest “large cap value” ETFs that have the word “dividend” in their names. Through three quarters of 2020, you can see a clear trend of under performance from dividend ETFs, in comparison to the “market”, or the S&P 500.
Even the best performing dividend ETFs fall short of the S&P 500. But what does that tell us?
Taking a deeper look, you can see that the real driver of S&P 500 performance is a handful of large cap tech stocks. Looking at any index not dominated by these outliers, you can see a more comprehensive representation of the market (e.g. S&P 500 equal weight).
But even looking at the S&P 500 equal weight, we can see that most dividend ETFs have underperformed in 2020 (just to a lesser degree). To understand why, we can look at the types of companies in dividend portfolios.
Two Dividend Stock Segments Tend to Underperform in Weak Markets
“Dividend” ETFs are frequently based upon a passive index, while few are actively managed. A passive index does not normally include a mechanism to adjust to multiple, coexisting factors. One passive strategy simply buys the highest yielding stocks as of quarter end with screens for minimum size. This index is vulnerable to two weaknesses that can surface during periods of economic weakness.
The first involves companies that have shrunk from their dividend. To us, this means that the company’s dividend yield is high because the business has deteriorated, and investors are anticipating a dividend cut or elimination.
The second segment includes companies that are highly leveraged. These companies are more capital intensive and carry more debt. Consequently, they are more leveraged to changes in economic trends and can easily underperform in weaker markets.
Strategies to Mitigate Dividend Underperformance in Weak Markets
As shown in the data above, our dividend portfolio has trended toward the top of the sample in times of decline. Now we won’t try to sell our strategy, but will look at some of the methods we use as an example of how to reduce underperformance in markets where dividend portfolios are vulnerable.
All passive dividend ETFs are built around an index and managed around one or more factors. Our approach resolves around fundamental market pricing and sector valuation, a hands-on and meticulous process, but one that is well worth it (in our opinion).
Here are the steps followed:
Step 1 – Identify attractive indices
We evaluate indices based upon historical relative strength in all market environments, offering a strong foundation upon which holdings are selected. As an example, we owned two “dividend” ETFs at the beginning of the year. One did poorly in the decline and initial rebound. We sold that ETF in April. The other did relatively well and remains in the portfolio. Given the relatively poor performance of passive “dividend” ETFs one may not be surprised to find very few in our portfolio.
Step 2 – Select fundamentally sound funds
The portfolio includes a significant allocation to sector funds that represent exposure to historically lower price volatility, and that also align with our broader sector valuation work.
Step 3 – Monitor sector valuations and adjust the portfolio accordingly
The technology sector has been included in all of our growth-oriented portfolios over the last two years. So it’s no surprise that we have included a technology fund in this portfolio. The technology exposure has been implemented with an ETF that requires dividend yield in the selection criteria. This will typically favor larger, more seasoned technology companies. Even so, as the technology sector has become more over-valued and volatile, we have gradually reduced the allocation to this holding over the last two years.
What Does the Future Hold for Dividend Stocks and Portfolios?
There are a few key indicators to look at when assessing the future of dividend stocks and portfolios.
Overall Dividend Expectations
During the first quarter market decline, futures for the 2020 S&P 500 dividend dropped from a high of $61.50 to a low of $40. It has since risen with the rebound in stocks, and currently stands at $57.85. The 2021 contract traded down to $35 and currently trades at $54.80 (still indicating a slightly lower rate than 2020).
Key Takeaway – Dividend expectations are lower, but stabilizing – not dissimilar to the trajectory of earnings expectations. Trailing 12-month earnings are forecast to exceed their pre-pandemic peak by the 4th quarter of 2021, and dividend changes tend to lag earnings. If earnings forecasts are exact (they never are), we would expect dividends on the broad index t exceed prior highs sometime in 2022. To date, dividend cuts have been concentrated in pandemic-stricken industries and highly leveraged companies.
The potential Impact of Tax Policy Changes
While future tax policies are always an unknown, we face what may be a binary outcome in the very near future. Either the potential for dramatic changes in tax rates is mitigated with the prospect of a divided government, or Washington will be controlled by the democratic party (Georgia’s runoff elections in January will ultimately tell).
The democratic platform includes plans to increase taxes. In today’s low yield environment, the absolute impact of a tax increase is relatively small. For example, if the tax rate of dividends increased from 15% to 35% an investor would see a decline in “take home” income of 40bps (1.30% vs. 1.70%).
Key Takeaway – Absolute and relative performance of principal may over-shadow a change in tax policy. Over the last two years, we have witnessed a number of moves into value stocks (typically the universe that includes higher dividend payers), but each time growth has re-asserted its leadership. Even in the last two months since the September 2nd high on the Nasdaq, there have been dramatic daily and weekly swings in relative performance.
The broad stock market is over-valued. The overvaluation is more extreme in the growth segment and less so in value. However, as we witnessed in the spring, relatively “less over-valued” does not always cushion realized volatility. Ultimately, a broader stabilization in the economy will allow value and dividend stocks to perform relatively well. Another economic downturn would likely be unkind to all stocks as we witnessed in the spring.
Potential Trouble in Financials
The January runoff election in Georgia may portend another dividend investor concern. Politicians in both parties have called for increased scrutiny and regulation of the financial sector, in particular big banks. One-party control of Washington may facilitate legislation in this regard. If so, it could lead to lower earnings and reduced (or regulated control of) capital returns to shareholders.
Key Takeaway – Review your dividend portfolio’s exposure to financials. Our High Dividend Growth portfolio has a modest 3.5% allocation to financials (not including preferred holdings, which should be less impacted). We will monitor the developments and manage accordingly.
An over-exposure to financials, which isn’t uncommon in dividend portfolios, could be vulnerable in a unified democratic government.
In Summary
While dividends have underperformed and 2020, and face some challenges in 2021, there is certainly a place for them in portfolios that require regular income generation. As always, we feel fundamental pricing and valuation strategies can shed light on portfolio strengths and vulnerabilities. It is time to stay prudent and keep an eye out for regulatory impacts in the new year, as well as shifts in the market cycle.
Do you want to learn more about dividend portfolios or have a question about this content? Contact us today at engage@aamamail.com. We’d love to speak with you.
Stay Up to Date
Want to stay up to date with fundamentally-driven market insight, economic analysis, and practice management advice?
Sign up to receive regular roundups of our content, delivered conveniently to your inbox.