High dividend yields: Reward is worth the risk

Dividend investing probably has never been so fashionable and so rewarding, particularly against the backdrop of record-low interest rates.
For many income-seeking investors, the stock dividend has emerged over the past few years as the new bond. And as with bonds, investors generally have embraced the notion that higher yields represent higher risks.
The trouble is, that isn’t necessarily the case with dividends.
Although a rising dividend yield usually represents a falling stock price, it rarely says much about why or for how long the stock price will decline.
“Just because a stock has dropped in value doesn’t necessarily mean it is going to drop further, and it is always possible that the stock has overcorrected,” said Bruno del Ama, chief executive of Global X Management Co. LLC.
He isn’t suggesting that investors start piling into stocks with spiking dividend yields but that investors could benefit by stepping out of their comfort zone with regard to yields.
Although everyone appreciates more dividend income, it’s the dividend yield, which is the dividend payout amount divided by the stock price, that can send mixed signals.
“Conventional wisdom holds that higher dividend [yield] means lower performance, but our research shows the opposite,” Mr. del Ama said.
TOTAL RETURN
In an analysis of total return across multiple categories of dividend yield, he found that higher-yielding stocks not only outperform lower-yielding stocks but also generate better risk-adjusted returns.
From a global universe of public companies with a market capitalization of at least $500 million, Global X created six categories of 60 stocks each, with each category representing a different dividend yield range, from no dividend to a yield of more than 17%.
For the 10-year period through December, the category with yields of between 10% and 17% had the best annualized return of 18.7%, followed by the 17%-plus category at 15.9%.
The lowest performance, at 10.8%, came from the stocks not paying dividends. The categories of stocks yielding 0%-2%, 2%-6% and 6%-10% had annualized returns of between 11.9% and 12.7%.
Volatility, as measured by standard deviation, does increase with the higher yields, topping out at 25.3% for the 17%-plus category.
But the second-most-volatile category was the non-dividend payers at 23.9%, which was higher than the 10%-17% yield category at 22% standard deviation.
Perhaps most important, the 10%-17% yield category stood out on a risk-adjusted basis.
Applying a Sharpe ratio to calculate the excess return per unit of risk measured by the standard deviation produced a 0.8 ratio for the 10%-17% category, followed by a Sharpe ratio of 0.6 for both the 2%-6% and 6%-10% categories.
The research findings are counterintuitive to a degree, but they also generally are in line with a variety of proven investing strategies.
“It is a known fact that higher dividends do better than the broad market, with better risk-adjusted returns,” said Jay Wong, a portfolio manager at Payden & Rygel, a $65 billion asset management firm.
“That’s how we manage our dividend stock fund, as well,” he said. “But you have to look at the fundamentals driving those yields, because yield alone can be a very dangerous way to look at dividend stocks.”
Mike Boyle, portfolio manager at Advisors Asset Management Inc., draws parallels between the Global X research and his own dividend investing strategy.
“We look at any stock greater than $1 billion market cap across 10 respective sectors and then we pick the five stocks in each sector with the highest dividend yield,” he said.
The strategy, which is managed in a unit investment trust wrapper, holds the 50 stocks for 15 months and then liquidates, so the strategy functions almost like a bond.
Advisors Asset Management has $8 billion under supervision.
Judging by the performance and risk-return disparity that kicked in for the highest-yielding category in the Global X study, it is clear that there are yield limits to be respected, and so diversification is key.
But much of the performance from the higher-yielding category can be explained by looking at the makeup of the stocks in the 10%-17% category, according to Mr. del Ama.
USING ETFs
As might be expected, 55% of the stocks in the category had higher yields due to a stock price decline, 24% hit the mark through dividend increases, and 21% were consistent high-dividend payers.
Mr. del Ama, whose firm has $1.2 billion under management, applies a variation of the high-dividend strategy in the form of exchange-traded funds.
The $365 million Global X SuperDividend ETF (SDIV), launched in 2011, is a global fund comprising the 100 highest-yielding dividend stocks up to a yield of 20%.
The fund has a 7.5% dividend yield, after expenses, and last year gained 16.6%.
Last week, Global X launched a U.S. version of that strategy, Global X SuperDividend U.S. ETF (DIV), which will apply the same investing rules for a portfolio of 50 domestic stocks.