Larry Swedroe sits down to talk authorship, factor investing, smart beta and how to prevent political views from impacting your investment decisions in an interview with Robin Powell ahead of this year’s new Evidence-Based Investing Conference.
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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANC
Research has established that dividend policy should be irrelevant to stock returns, yet investors have long demonstrated an irrational preference for them. Mutual fund providers are well-aware of this fact.
Earlier this week, we reviewed a pair of studies showing that mutual fund managers exploit investors’ well-documented preference for cash dividends to attract assets by artificially “juicing” the dividend yield, and that they use dividend-chasing behavior strategically to benefit themselves at the expense of fund investors. Today we’ll tackle some possible explanations for investors’ anomalous behavior.
Attempting To Explain The Preference For Dividends
Hersh Shefrin and Meir Statman, two leaders in the field of behavioral finance, attempted to explain the preference for the cash dividends anomaly in their 1984 paper, “Explaining Investor Preference for Cash Dividends.” They offered the following explanations.
First, in terms of their ability to control spending, investors may recognize they have problems with the inability to delay gratification. To address this problem, they adapt a “cash flow” approach to spending, meaning they limit their spending only to the interest and dividends from their investment portfolio.
A “total return” approach that used self-created dividends would not address the conflict created by the individual who wishes to deny himself or herself a present indulgence, yet is unable to resist the temptation. While the preference for dividends might not be optimal (for tax reasons), by addressing the behavioral issue, it could be said to be rational. In other words, the investor has a desire to defer spending, but knows he doesn’t have the will, so he creates a situation that limits his opportunities and, thus, reduces the temptations.
The second explanation is based on “prospect theory” (also referred to as loss aversion), which states that investors value gains and losses differently. As such, they will base decisions on perceived gains rather than on perceived losses.
So, if someone were given two equal choices, one expressed in terms of possible gains and the other in terms of possible losses, people would choose the former. Because taking dividends doesn’t involve the sale of stock, it’s preferred to a total-return approach that may require self-created dividends through sales. Sales might involve the realization of losses, which are too painful for people to accept (they exhibit loss aversion).
What they fail to realize is that a cash dividend is the perfect substitute for the sale of an equal amount of stock, whether the market is up or down, or whether the stock is sold at a gain or a loss. It makes absolutely no difference. It’s just a matter of how the problem is framed. It’s essentially form over substance.
Whether you take the cash dividend or sell the equivalent dollar amount of the company’s stock, you’ll end up with the same amount invested in the stock. With the dividend, you own more shares but at a lower price (by the amount of the dividend), while with the self-dividend, you own fewer shares but at a higher price (because no dividend was paid).
Consolation Prizes
Shefrin and Statman write: “By purchasing shares that pay good dividends, most investors persuade themselves of their prudence, based on the expected income. They feel the gain potential is a super added benefit. Should the stock fall in value from their purchase level, they console themselves that the dividend provides a return on their cost.”
They point out that if the sale involves a gain, the investor frames it as “super added benefit.” However, if the investor incurs a loss, he frames it as a silver lining with which he can “console himself.” Because losses loom much larger in investors’ minds, and because they wish to avoid them, they prefer to take the cash dividend, avoiding the realization of a loss.
Shefrin and Statman offer yet a third explanation: regret avoidance. They ask you to consider two cases:
1) You take $600 received as dividends and use it to buy a television set.
2) You sell $600 worth of stock and use it to buy a television set.
After the purchase, the price of the stock increases significantly. Would you feel more regret in case one or in case two? Since cash dividends and self-dividends are substitutes for each other, you should feel no more regret in the second case than in the first case. However, evidence from studies on behavior demonstrates that, for many people, the sale of stock causes more regret. Thus, investors who exhibit aversion to regret have a preference for cash dividends.
Shefrin and Statman go on to explain that people suffer more regret when behaviors are taken than when behaviors are avoided. When selling stock to create the homemade dividend, a decision must be made to raise the cash. When spending comes from the dividend, no action is taken; thus, less regret is felt. Again, this helps explain the preference for cash dividends.
The authors also explain how a preference for dividends might change over an investor’s life cycle. As mentioned previously, a theory incorporating self-control is used to justify spending only from a portfolio’s cash flow, never touching the principal.
Younger investors, who generate income from their labor capital, might prefer a portfolio with low dividends, as a high-dividend strategy might encourage dis-savings (spending from capital). On the other hand, retired investors with no labor income would prefer a high-dividend strategy for the same reasons, to discourage dis-savings. A study of brokerage accounts found that a strong and positive relationship between age and the preference for dividends did in fact exist.
While the preference for cash dividends is an anomaly that cannot be explained by classical economic theory (which is based on investors making “rational” decisions), investors who face self-control issues (such as a weakness for impulse buying) may find that, while there are some costs involved, the benefits provided by avoiding behavioral problems may make a cash dividend strategy a rational one.
Before summarizing, we have one more important point to cover. It involves how popularity drives down returns.
The Curse Of Popularity
The Federal Reserve’s zero-rate policy has led many investors to search for incremental yield, replacing safe bonds with riskier assets. Dividend-paying stocks are among the beneficiaries of these cash flows. That increased demand has impacted valuations, which are the best predictors of future returns. Higher valuations predict lower future returns. Until recently, dividend-paying strategies—specifically high-dividend strategies—called for the purchase of value stocks. Increased demand, however, has changed that.
The table here shows three value metrics—price-to-earnings (P/E), price-to-book value (P/B) and price-to-cash flow (P/CF)—for two of the market’s most popular dividend strategies: the SPDR S&P Dividend ETF (SDY), with more than $14 billion in assets under management (AUM), and the Vanguard Dividend Appreciation ETF (VIG), with more than $22 billion in AUM. Data is as of July 13, 2016. VIG buys the stocks of companies with rapid growth in their dividends.
The table also shows the two large-cap value ETFs with the most AUM, the iShares Russell 1000 Value ETF (IWD) and the Vanguard Value ETF (VTV). Finally, I’ll compare the value metrics of these funds with that of the SPDR S&P 500 ETF (SPY). As you review the data, remember that the lower the price metric, the higher the expected return. Data is from Morningstar.
The above data makes clear that the popularity of the two dividend strategies (SDY and VIG) has led to a rise in the prices of these stocks and reduced their expected returns. No matter which value metric we look at, the expected returns for both SDY and VIG are now well below the expected returns of the two large value strategies, and also below that of the S&P 500 ETF. It’s an example of the curse of popularity, and what happens when a trade gets “crowded.” Forewarned is forearmed.
Summary
It seems that investors all over the world are prone to the same behavioral mistakes, mistakes that lead them into a preference for dividends. While Shefrin and Statman showed that at least some investors may derive some benefit (such as help in controlling spending), the preference is irrational from a financial economist’s perspective. It can lead to reduced diversification benefits and higher tax costs. And it can lead at least some investors to fall prey to mutual funds seeking to exploit the typical retail investor’s lack of financial knowledge.
For the past 20 years, the workhorse model in finance has been the Fama-French four-factor model—the four factors being beta, size, value and momentum. The model explains the vast majority (about 95%) of the differences in returns of diversified portfolios.
Newer asset pricing models, which include the profitability, quality and investment factors, have added further explanatory power. Yet none of them include dividends as a factor. If dividends played an important role in determining returns, these models wouldn’t work as well as they do.
In other words, if dividends added explanatory power beyond that of the factors I just mentioned, we would have a model that included dividends as one of the factors. But we don’t. The reason is that stocks with the same “loading,” or exposure, to these common factors have the same expected return regardless of the dividend policy. This has important implications, because about 60% of U.S. stocks and about 40% of international stocks don’t pay dividends.
Any screen for dividend stocks results in portfolios that are far less diversified than they could be if dividends were not included in the portfolio design. Less diversified portfolios are less efficient, as they have a higher potential dispersion of returns without any compensation in the form of higher expected returns (assuming exposures to the factors are the same).
Additionally, you have seen how the preference for dividend stocks has driven dividend strategy valuations to levels well above the valuations of value strategies and the overall market. This should raise concerns about future returns.
This commentary originally appeared August 17 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE
It has long been known that many investors have a preference for cash dividends. From the perspective of classical financial theory, this behavior is an anomaly. The reason is that, in their 1961 paper, “Dividend Policy, Growth, and the Valuation of Shares,” Merton Miller and Franco Modigliani famously established that dividend policy should be irrelevant to stock returns. This theorem has not been challenged since. Moreover, the historical evidence supports this theory, which is why there are no asset pricing models that include a dividend factor.
Given the combination of logic and historical evidence, the preference for dividends among individual investors is perplexing behavior. It’s perplexing because, before taking into account what are referred to as “frictions” (such as transaction costs and taxes), dividends and capital gains should be perfect substitutes for each other. Stated simply, a cash dividend results in a drop in the price of the firm’s stock by an amount equal to the dividend. This must be true, unless you believe that $1 isn’t worth $1. Thus, investors should be indifferent between a cash dividend and a “homemade” dividend created by selling the same amount of the company’s stock. One is a perfect substitute (excluding any frictions) for the other.
Without considering frictions, dividends are neither good nor bad. However, once the friction of taxes is considered, investors should favor self-dividends (selling shares) if cash flow is required. Unlike with dividends, where taxes are paid on the distribution amount, when shares are sold, taxes are due only on the portion of the sale representing a gain. And specific lots can be designated to minimize taxes.
Because the investor preference for cash dividends has been well-documented, it should not come as a surprise that mutual funds have been exploiting this knowledge and attract assets by “juicing” the dividend. We’ll take a look at two recent papers examining how mutual funds exploit investors’ anomalous behavior.
Mutual Funds Exploit Investor Preferences
Lawrence Harris, Samuel Hartzmark and David Solomon, authors of the paper “Juicing the Dividend Yield: Mutual Funds and the Demand for Dividends,” which was published in the June 2015 issue of the Journal of Financial Economics, found that some mutual funds purchase stocks before dividend payments as a way to artificially increase their dividends. In fact, greater than 7% of the authors’ fund-year observations had dividend payments more than twice as large as their holdings imply. The authors called this behavior “juicing.”
Mutual funds can meet investors’ desire for large dividend payments in two ways. Either they can buy high-dividend-yield securities, or they can artificially increase their dividend yields by “buying the dividends” (or “juicing” them). The process involves purchasing stocks before the day on which the dividend will accrue to investors (known as the “ex-dividend day”), collecting the dividend and then selling the stock afterward.
The authors observed that a few funds actually advertise their juicing behavior. In 2010, Morningstar identified an illustrative list of seven funds that explicitly describe a juicing strategy in their prospectuses. The properties of these funds are sometimes quite astounding. The authors noted that in 2009, the First Trust Dividend and Income Fund (FAV) listed a ratio of income to assets of 19.3% and an annual turnover rate of more than 2,000%.
The authors found that juicing is a persistent, and thus predictive, behavior. Funds that juice in one year (i.e., have an excess dividend ratio outside what chance alone would predict) are much more likely to juice in other years. This is consistent with juicing being a deliberate behavior.
Not unexpectedly, the authors found that juicing is costly to investors through higher trading costs (commissions, bid/offer spreads and market impact costs). They found that funds with an excess dividend ratio above 1.38 have turnover 11% higher (with a t-stat of 4.2). Funds with an excess dividend ratio above 2 have turnover 17% higher (with a t-stat of 4.0). In addition, juicers incur increased taxes, ranging from 0.6% to 1.5% of fund assets per year. And this assumes that all dividends are qualified.
The implication is striking: “Investors who seek an income stream are better off creating it by selling fund shares than by investing in a fund that juices.”
Juicing Drives Inflows
Despite the many issues with juicing, Harris, Hartzmark and Solomon found that funds with an excess dividend ratio greater than 1.38 received on average an additional 6.8% of inflows a year when compared with other funds with similar observable characteristics. An excess dividend ratio greater than 2 is associated with an additional 12.2% of inflows a year.
Furthermore, the authors sought to identify who bought funds that engaged in this bad behavior. The hypothesis would be that juicing must appeal to less-sophisticated, uninformed investors. Consistent with this expectation, juicing is significantly less likely for funds with institutional share classes (institutions are considered to be more informed).
In addition, dividends should be more valuable to investors with lower income tax rates, or to those who pay no income tax at all. Yet juicing is more likely to occur among retail funds, whose investors have a greater likelihood of paying income taxes on dividends when compared with institutional funds (which are more likely to have tax-free investors such as retirement accounts or charitable institutions).
Perhaps not surprisingly, given the less-sophisticated nature of their buyers, the authors also found that juicing is more common among funds with higher expenses (which further serve as a drag on returns).
Finally, the authors noted their results are consistent with investors who psychologically distinguish between consuming income produced by their assets and consuming the capital value of their assets. This is simply a labeling error (or a framing problem), and thus leads to irrational behavior. Unscrupulous mutual funds, however, cater (or pander) to unsophisticated investors, charging higher fees and delivering lower returns with less tax efficiency.
Supporting Evidence
We now turn to a July 2016 study, “Strategic Use of Dividend Payments by Mutual Funds.” The authors used a unique sample of open-ended Chinese mutual funds, the rationale being that these funds have flexibility in their dividend policies. This isn’t the case in the United States and many other countries, where mutual funds are required by tax law to ‘‘pass-through’’ essentially all investment income to fund investors. Thus, in the latter case, the amount of dividend a fund could pay largely depends on the composition of the fund portfolio.
The authors, Jun Xiao, Mingsheng Li and Yugang Chen, tested whether the Chinese funds pay dividends in order to either cater to investors’ demand for cash or to exploit investors’ imperfect rationality to serve the fund managers’ own interests. They note: “Unlike U.S. mutual funds, the Chinese open-ended mutual funds are very flexible in dividend policy because there is no such ‘pass-through’ rule in China. The main restrictions related to dividend distribution in China are that the net asset value after dividend distribution is no less than its book value and that the maximum amount of dividend to be distributed cannot be greater than either the undistributed gains or the realized undistributed gains.”
Their study covered the period 2003 through 2012. Following is a summary of their findings:
The authors concluded: “These results suggest that fund managers take advantage of the individual investor’s irrational dividend chasing behavior, thereby using dividends strategically to benefit managers at the expense of fund investors.” In other words, they prey on investors in order to benefit themselves.
A logical question that arises from the authors’ findings is: If high-dividend-paying funds underperform other funds, why do investors put more money into them? They speculate that this puzzling anomaly may be explained by the irrational behavior of individual investors. Later this week, we’ll review some additional research from the field of behavioral finance that seeks to explain the irrational preference among investors for dividends.
This commentary originally appeared August 15 on ETF.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE