The Relevance of Dividend Irrelevance

dividends are irrelevant in explaining differences in expected returns building investment portfolios based on dividends results in lower expected returns when yield is in high demand a lack of diversification tax inefficiency and an arbitrary retirement spending rule dictated by corporations basing investment or consumption decisions on dividends does not make sense i'm ben felix portfolio manager at pwl capital and i'm going to tell you why dividend irrelevance is relevant to good financial decisions dividend irrelevance was shown theoretically by miller and madigliani in 1961. farmer and french showed empirically in their 1993 paper common risk factors and the returns on stocks and bonds that portfolios formed based on their dividend yield have three factor alphas that are statistically indistinguishable from zero this means that after controlling force sensitivity to market risk company size and relative price dividends do not contain any additional information about expected returns i updated these data using the more recent five factor asset pricing model from fama and french which includes profitability and investment for the full histories of an international developed high dividend index and a u.s high dividend index i again find alphas statistically indistinguishable from zero in other words sensitivity to market beta company size relative price profitability and investment explained 100 of the returns of a portfolio formed on dividends stated another way dividends contain no information about expected returns that is not already captured in the five factor asset pricing model this is exactly what valuation theory predicts the dividend discount model says that the theoretical value of a share of stock is the discounted value of expected dividends per share but with dividend policy irrelevance the value of a firm is based on expected earnings minus expected investment this is the theoretical basis for the factors in the five factor asset pricing model this is relevant because well portfolios formed on things like dividend yield or dividend growth may have exposure to low priced stocks with robust profitability which is a good thing dividends are just a noisy and inefficient way of getting there to understand why we need to start by understanding dividend investors at the core of the theory of dividend irrelevance is fungibility investors should treat money equally regardless of its source however dividend investors do not view dividends and capital gains as fungible in that sense dividends are relevant but not in the way that dividend investors would hope in the 2019 paper the dividend disconnect heartsmark and solomon find that investors view dividends as free money and account for them separately from capital gains they call this the free dividends fallacy the effect makes a stock that pays a dividend seem more attractive than one that doesn't hartsmark and solomon find that dividend investors are willing to pay a premium for dividend cash flows above and beyond what a rational investor would they find that dividend demand is higher when interest rates are low and this effect is more pronounced for stocks whose dividends are more stable or have increased in the recent past they estimate that investors buying dividend-paying stocks during times of high demand for yield reduced their expected returns by roughly two to four percent per year in other words when dividends are in high demand like when interest rates are low there is a good chance that dividend investors are overpaying for their dividend cash flows additionally investors forming their portfolios on dividends end up with a built-in mechanism for under diversification by nature of the fact that a huge portion of stocks don't pay dividends in the us at the end of 2021 only about 38 percent of stocks paid dividends dividend labels like high dividend or dividend growth also obscure the underlying characteristics that investors are getting exposure to etfs representing common dividend strategies like dividend growth typically underweight smaller companies that's not good in the 2020 paper settling the size matter blitz and hanauer find that risk premiums like value and profitability tend to be larger among small cap stocks to the extent that a dividend focus results in a tilt away from smaller companies dividend investors may be missing out on expected returns to be fair it is possible to invest in small cap dividend growth stocks but the reduction in diversification by requiring dividends is even more impactful in small caps despite a higher expected returns in aggregate individual small cap stocks display more return skewness and a higher frequency of underperformance than larger stocks small cap dividend growth funds also tend to have higher fees and higher turnover while not delivering anything special in terms of expected returns that could not be obtained through more diversified lower cost and lower turnover small cap value funds dividend-focused portfolios also tend to concentrate on specific industries some industries tend to have higher yields others have more attractive dividend growth and so on so different dividend strategies will deliver different industry tilts this matters because sector bets are not compensated in pursuing the expected value and profitability premiums which are really what dividend investors are seeking exposure to whether they realize it or not realistically a little bit of industry over end underweighting is inevitable in pursuit of value and profitability but allowing dividends which are not related to expected returns to dictate industry tilts introduces completely unnecessary uncompensated risk adding to the diversification problem for dividend investing domestic dividends are often more favorable from a tax perspective making global diversification much more expensive for a dividend investor finally from a financial planning perspective dividend investors consumption is highly sensitive to dividends in the 2020 paper stock market returns and consumption dimaggio kermani and malaysia find in swedish data that household consumption is significantly more responsive to dividend payouts across all parts of the wealth distribution consistent with households treating capital gains and dividends as separate sources of income in the 2022 paper consuming dividends brower hackathon hanspell find in detailed daily data from a german bank that private consumption is excessively sensitive to dividend income and that investors across wealth income and age distributions increase spending precisely around days of dividend receipt their results suggest that consumption response to receiving dividends reflect planned consumption driven by investors who buy dividend stocks intentionally anticipate dividend income and plan consumption accordingly this is a problem dividends are a rather arbitrary approach to determining the magnitude and timing of consumption total returns are harder to think about with respect to consumption because they aren't explicit cash flows but this is easily resolved through financial planning defining a desirable consumption path determining how much can be sustainably spent from a portfolio following that path and then spending sustainably from the portfolio regardless of the source of returns spending dividends can be thought of as a variable spending strategy rather than spending the same dollar amount you spend whatever your dividends are variable spending is a good thing it is more efficient than trying to spend the same dollar amount adjusted for inflation from a portfolio each year more consumption variability allows retirees to consume more of their wealth while they are alive this is known as consumption efficiency variable spending does not require dividends though one way to accomplish variable spending without relying on dividends is to spend some percentage of the portfolio each year but only increase or decrease the prior year's dollar spending amount by a ceiling and a floor for example you start with four percent of a one million dollar portfolio in year one forty thousand dollars in year two the portfolio is only worth eight hundred thousand dollars but instead of cutting spending to thirty two thousand dollars you only cut it to the maximum five percent year to year change thirty eight thousand dollars the ceiling and floor on spending variability can be increased or decreased depending on your preferences less variability and consumption is less efficient but for someone with a strong preference for stable consumption inefficiency is just a trade-off it's not necessarily a downside the optimal spending strategy for each individual depends on their preferences which highlights one of the big problems with leaving consumption decisions to corporate dividend policies the other problem here is that dividends are empirically inefficient relative to other variable spending strategies to illustrate this we use the top 30 percent highest dividend yield u.s stocks from 1927 to march 2022 and modeled rolling 30-year withdrawal periods we tested 1000 possible variable spending strategies with incrementally increasing spending flexibility and compared them with spending dividends given a level of total consumption we found that spending dividends resulted in a lower ending net worth given a standard deviation of monthly consumption we found that spending dividends resulted in a lower ending net worth and given a standard deviation of monthly consumption we found that spending dividends resulted in an approximately equivalent total consumption stated simply given a financial planning objective spending dividends is probably an inefficient way to achieve it finally dividends are not an inflation hedge in the u.s data there's no strong evidence that dividend stocks have delivered improved inflation-adjusted performance during periods of high inflation or rising interest rates and globally real dividend growth over the last 120 years has been negative for about half of the countries that we have data for dividend policy is theoretically irrelevant to expected returns empirically dividends do not explain differences in returns between diversified portfolios once company size relative price profitability and investment are accounted for as valuation theory predicts in reality investors really like dividends which can result in them overpaying for yield when yield is in high demand driving down their expected returns focusing on dividends in portfolio construction rather than on the drivers of expected returns can result in an unnecessary reduction in diversification and an increase in tax drag in addition to being inefficient for portfolio construction dividends defer retirement consumption decisions to corporations rather than being tailored to the preferences of each individual given a financial planning objective like maximizing ending net worth maximizing consumption or minimizing the variability of consumption spending dividends is typically an inefficient way of getting there dividend paying stocks do often have some attractive characteristics but those characteristics can be targeted directly without the completely unnecessary dividend filter thanks for watching i'm ben felix portfolio manager at pwl capital if you enjoyed this video please share it with someone who you think could benefit from the information we also discussed this topic in more detail in episode 201 of the rational reminder podcast [Music] you

Channel: Ben Felix

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Length: 11min 6sec (666 seconds)

Published: Thu Jun 09 2022