Why Does Larry Swedroe Hate Dividends?
By Roger Nusbaum, AdvisorShares ETF Strategist
A couple of different things today.
First is a write up from Larry Swedroe that shows dividend investing doesn’t really outperform or reduce volatility by a significant amount. Larry provides plenty of data to support his thesis and yes, based on the data as presented, there is no performance advantage. I believe however that there might be a flaw in the process due to the time period studied combined with what Larry used to draw his conclusion. He looked at dividend based ETFs, noting the first one was issued in 2003. There were many more that came out shortly thereafter.
Here’s the problem; back in 2003, 2004 and so one when the first dividend centric funds came out, most of them were grossly overweight to financials. I wrote about practically all of them for The Street.com and made that same point in every article. I certainly wasn’t predicting the crisis but any strategy that is thought of at least partially broad based but 40-50% in one sector needs to be approached with caution.
If Larry had been able to study dividend indexes that covered a longer period of time the results probably would have been different (worse for all I know). Dividend investing is of course valid but I would urge caution against dividend only (a point of contention with Seeking Alpha readers in years past) as it limits diversification. Diversification means having holds with many different attributes and that doesn’t describe a dividend only portfolio.
Where some portion of a portfolio’s return comes from price appreciation and some portion comes from yield the way I have framed it is that if the S&P 500 has about a 2% yield which has been the case for several decades and the portfolio can be built to yield something like 3% then the portfolio doesn’t have to work quite so hard (take on as much volatility) to keep up with the S&P 500 or whatever the benchmark might be. At some point a high yield becomes too high in terms of the risk and volatility taken to get that yield. Not that a holding with a 7% yield should not be sought but there are risks in getting a 6 or 7 or 8% yield in a 1% world.
I stumbled across an article from a couple of years ago titled Volatility as an Asset Class from Pensions & Investments. I don’t think the article actually made the case for volatility as being an asset class but did lay out an interesting strategy that if actually doable, could be a way to put volatility to work in a portfolio. The basic premise was to turn a stock into a bond.
The example given was to buy a stock at $100, sell a call struck at $85 that expires in one year for $23. The idea is that the stock is very likely to get called away at $85 so the investor loses $15 on the stock, makes $23 selling the call and profits on the difference, 10.38% by the author’s reckoning. As presented, substituting for a fixed income strategy, of course it is interesting enough to prompt a closer look.
To get any meaningful time premium out of a deep in the money call you need to look at volatile stocks, mega cap potato chip incorporated will not give you 10% in time premium on a deep call. I looked at three different volatile stocks with options to try to get some real-world examples. I looked at January 2019, there’s no September 2018. Naming names is problematic for compliance reasons but the first stock is at $140 and a Jan ’19 call struck at $120 had a bid of $33 so the time premium was $13.
The second stock was at $190 and a call struck at $160 with a Jan ’19 expiration was bid at $48.50 so it had $18.50 in time premium. And a final example trades at $107 and a call struck at $87.50 for Jan ’19 was bid at $26.50 so the time premium was only $6.50. The respective betas (not necessarily the best measure of volatility) were 1.08, 1.11 and 1.24. The betas surprised me, I’d have thought the first two would have been much higher so there appears to be something to the strategy.
I would offer the following caveat that I also offered in a series of blog posts in 2008; the options market doesn’t give money away for free. On July 29, 2008 I wrote about a recommendation on CNBC back then to buy a somewhat volatile stock at $255 and selling a covered call struck at $270 that had a premium of $12. From that post;
…often with such a fat call premium the stock will either go down a lot or go rocketing past the strike. Although there are no absolutes to this sort of thing, changes in volatility usually happen for a reason.
Then a few days later;
After the segment on Monday the stock went up to $270 on Tuesday and then worked lower the rest of the week, it got as low as $225 on Friday before closing at $237.
This is a very difficult scenario to come out ahead with other than holding on but swings that big in just a few days are not easy for most folks. Even with deeps, the market does not give money away. Any of the examples above should be thought of as capable of falling below their respective breakevens (not a comment on fundamentals so much as a trading reality). Like with most strategies, small exposure that won’t be ruinous if it goes wrong is fine but this can be the sort of thing where yield chasing happens, ending in tears.
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