Does a high-dividend strategy help or hurt returns?

(MoneyWatch) As we have discussed many times, the low-interest-rate environment we have been living in for over five years has led many investors toward a strategy of investing in stocks that pay relatively high dividends. For example, the SPDR S&P Dividend ETF (SDY) now has $12 billion in assets under management, and the Vanguard High Dividend Yield ETF (VYM) has about $6 billion in assets under management.

Unfortunately, most investors don't stop and ask the questions: Is this a good strategy? Does it add to or subtract from overall returns? Complicating the matter is that the answer depends on how you frame the question. If you ask, "Does a strategy of buying stocks that pay relatively high dividends outperform the market?," the answer is yes. However, if instead you ask, "Is the source of the outperformance the high dividend yield?," the answer is no.

• Why invest in stocks with a high-dividend yield?
• Why chasing dividends is a mistake
• The returns of stocks with less risk?

The April 2013 study "Dividend Investing: A Value Tilt in Disguise?" covered the period August 1979-July 2012, analyzing the factors explaining the performance of a high-dividend portfolio -- the first decile of stocks when ranking by dividend yield. To answer the question, Gregg Fisher, the author, separated out the factors that explained returns such as value, growth, momentum and company size. The following is a summary of his findings:

• The high-dividend-yield portfolio's annualized return was1.27 percent above that of the total market as represented by the Russell 3000 index (12.42 percent versus 11.15 percent). So the high-dividend strategy outperformed the market.
• When the factors explaining the returns were decomposed, the dividend yield factor actually contributed negative 1.02 percent -- the high-dividend factor actually detracted from performance.
• The above-market return resulted from the high-dividend portfolio's exposure to value factors. Value, defined as the ratio of book value to price ratio, had a positive exposure of 0.5 and positive contribution of 0.4 percent, the third-highest contributor to the total returns. Earnings yield, defined as stock earnings per share divided by price per share, also had a positive exposure of 0.5 and is the highest contributor to total returns, adding 2.3 percent. This indicates that the portfolio of high-yield-dividend stocks also is tilted toward value and earnings yield, and that these factors (not the high-dividend yield) are contributing meaningfully to the portfolio's high returns.

Summarizing, this study demonstrates that by concentrating their portfolios on high-yield-dividend stocks, investors are unwittingly tilting their portfolios to value stocks. The dividend-yield factor is subsumed by value factors, which are responsible for the excess performance. In other words, a high dividend strategy is a poor value strategy, negatively impacting the returns of value strategies such as buying stocks with low price-to-earnings, low price-to-cash flow, low price-to-sales and low price-to-book market value.

There's one other factor to consider -- a high-dividend strategy is inherently more tax inefficient (even at today's tax rates, where dividends and long-term capital gains are taxed at the same rate) because they generate more current income.

The bottom line is that investors would be better served if, instead of tilting their portfolios to high-dividend-paying stocks, they tilted their portfolios to value stocks.