Why Don’t Couch Potato Portfolios Use Dividend ETFs?

A reader, L.P., asks the following question (edited for length and clarity):

“Why don’t sample couch potato portfolios in books and blogs use dividend ETFs for the equity portion? Wouldn't an ETF like VDY outperform XIU over the long haul? Long-term dividend investing has good historical returns. Higher dividends can accumulate over the long run. I'd imagine that a dividend ETF full of solid dividend payers would correlate closely with the general market performance if not slightly better in downturns? Is my thinking off?”

Thanks for the thoughtful question. First off, let me say that dividend investing can be a reasonable approach as long as investors are well diversified. Certainly, an ETF like Vanguard’s VDY is reasonably well diversified within Canada. However, some dividend investors go off the rails when they convince themselves that dividend-paying companies are much better than other companies.

Dividend stocks tend to be value stocks. An ETF like VDY will tend to perform similarly to a value stock index, although VDY is a little less well diversified because it omits value stocks with lower dividends. The total return, consisting of capital gain plus dividend, of dividend stocks will tend to be similar to the total return of value stocks. This means that dividend stocks with their higher dividend will tend to have lower capital gains than other value stocks.

If value stocks perform well over a given period of time, they could outperform a broad index ETF like XIU. Historically, there has been a value premium, but having a value tilt has performed better than focusing more narrowly on just dividend stocks.

You might see some analyses that seem to show that “solid” dividend stocks outperform the broader index by a wide margin. This is typically a result of survivorship bias. If we look at just companies that have paid increasing dividends for decades, it’s obvious that they have been great investments that have outperformed in the past. But there is no guarantee that this outperformance will continue into the future. Solid long-term dividend payers sometimes cut their dividend or go bankrupt. Think of GM and Kodak. If you don’t include the performance of GM and Kodak among other long-term dividend-payers, your analysis has survivorship bias.

As for dividend payers performing better in downturns, I think it is more likely that dividend investors perform better in downturns. This biggest risk during a downturn is that investors will lose their nerve and sell low. Some dividend investors ride out the temporary drop in stock prices by keeping their focus on the steady dividends.

In summary, while well-diversified dividend investing can work well for investors, it is not the path to outperformance that many think it is. The flip-side of higher dividend payments is typically lower capital gains. It is the total return of stocks that matters most in the long run.