GE shows what can go wrong with dividend strategy

General Electric’s decision to slash its dividend in half is a sharp reminder to investors that dividends aren’t forever — and that the income from funds and ETFs can come at a high price.

In the long run, dividends produce a third to a half of the return from stocks. For example, the Standard and Poor’s 500 stock index has gained 8.68% a year the past 40 years, according to Morningstar. Add in reinvested dividends, and the total return rises to 11.82% a year.

In the short run, however, dividend investors need to brace for some shocks. The first is a dividend cut, as GE investors realized Monday, when the company cut its dividend 50%, to 12 cents a share, as part of a turnaround strategy. Wall Street loathes dividend cuts even more than it loves dividend hikes. GE stock is now trading at $17.82 a share, its lowest point since 2011.

At the moment, dividend cuts are as rare as warm, sunny November mornings in Detroit: According to Todd Rosenbluth, director of ETF and mutual fund research at CFRA, S&P 500 companies were 34 times more likely to have raised dividends than to have cut them.

So far this year, many of the biggest dividend-oriented funds have lagged the S&P 500 — and not just because of GE. The $20 billion Vanguard High Dividend Yield ETF (VYM), for example, has gained 11.6% this year, vs. 17.5% for the S&P 500. iShares Core High Dividend ETF (HDV), a $6.5 billion fund, has gained 7.4%.

For many funds, however, the pain from GE will last, in part because most dividend ETFs are index-based and only reconstitute those indexes one to four times a year. “These are rules-based funds, even with the best of intentions, they can be fallible,” Mr. Rosenbluth said. He points to First Trust Morningstar Dividend Leaders Index Fund (FD), which has a 4.6% stake in GE. “Despite the dividend cut, GE is likely to remain in the portfolio for some time, as the index is reconstituted once annually each June and rebalanced four times annually in March, June, September and December,” Mr. Rosenbluth said.

GE, along with JPMorgan Chase, Pfizer and Wells Fargo, would not get into funds which require a long record of raising dividends. (GE last cut its dividend in 2009). ProShares S&P 500 Dividend Aristocrats ETF (NOBL), for example, invests only in companies with a 25-year history of continually raising dividends. The fund doesn’t own GE — or, for that matter, JPMorgan Chase, Pfizer and Wells Fargo. It’s up 14.3% this year.

And some actively managed funds can have a better chance of spotting dividend payers who may not be able to continue paying, Mr. Rosenbluth said. For example, Columbia Dividend Income (LBSAX) focuses on companies that management believes are disciplined and have a history of above-average dividend growth.

“GE’s dividend cut was not a shock to the investment community,” he said. “GE was not a holding as of the end of September, but AAPL, Johnson & Johnson and Microsoft were,” he said.

Dividend-paying companies have had a tail wind for nearly a decade, in part because yield-starved investors couldn’t get income safely from bank CDs and bonds. But that could be changing soon: The Federal Reserve is likely to raise interest rates in December and two or three times in 2018. That would bring interest rates on bank CDs and money market funds to about 2% — which is the current S&P 500 dividend yield. While dividend stocks have many advantages, including the ability to raise dividends, some investors might decide that the stocks just aren’t worth the short-term risk.