Why a high-dividend strategy is dangerous

(MoneyWatch) The financial media and much of Wall Street continue to tout high-dividend strategies as a way to cope with the historically low level of interest rates. However, such strategies have a host of issues, especially when used in place of high-quality bonds and similar instruments.

Today, we have a new significant problem for investors who have become enamored of the high-dividend strategy -- this one of their own making. The popularity of approach has led to a flood of money into funds that focus on high-dividend strategies, funds such as the SPDR S&P Dividend ETF (SDY).

But here's why you should beware.

• Don't rely on dividend strategies to pick stocks
• Why you should be wary of stocks that pay dividends
• The dangers of dividend-paying stocks

Individual investors have a long history of chasing the latest fad. Those investor cash flows ultimately lead to high valuations, which predict lower future returns. We see the evidence in looking at the accounting metrics for SDY. We'll compare it to an S&P 500 Index fund; two value funds (as the high-dividend strategy is basically a value strategy); and another fund focusing on dividends (though it focuses on growth of dividends):

• The Vanguard 500 Index Fund (VFINX)
• The Vanguard Value Index Fund (VIVAX)
• The Dimensional Fund Advisors Large Value Portfolio (DFLVX)
• The Vanguard Dividend Appreciation ETF (VIG)

As you can see, the high dividend and fast growth of dividend strategies have the highest prices relative to each of the four metrics. Thus, they have the lowest expected returns. The two value funds, as we would expect, have the lowest metrics, and thus the highest expected returns. While sacrificing the stability of safe bonds, investors in these strategies are accepting the risks of stocks, but have the lowest expected returns.

While keeping these facts in mind, let's briefly review some of the arguments against a high-dividend strategy. Following this strategy is far riskier than staying in high-quality bonds, so comparing the two is like comparing apples to oranges.

For example, over the last 60 years, the worst one-year, two-year and three-year total return to a high dividend strategy has been -36.3 percent, -39.7 percent and -33.6 percent, respectively. For five-year Treasuries, the worst total returns were -5.1 percent, -1.7 percent and 1.6 percent, respectively. In addition, the annual volatility of a high-yield strategy is more than three times that of five-year Treasuries. Clearly, a high dividend strategy isn't a substitute for safe bond investments.

Nothing in the historical data suggests that high-dividend strategies are either an appropriate substitute for high-quality bonds or are the best way to gain exposure to value stocks. A high-dividend approach has substantially more risk, substantially lower returns and poorer risk-adjusted returns compared with other value strategies.

In closing, it's important to remember that whenever too much capital piles into any given approach, returns suffer. Here's something else to remember: An unpopular asset class/investment strategy is usually held by strong, disciplined hands (such as Warren Buffett). When bear markets occur, these investors not only hold on, they also tend to buy more.

On the other hand, when everyone owns a given asset class/approach, there are a lot of weak hands holding them. Weak hands tend to push the panic button during bear markets. And that leads to the all too common behavior of investors buying high and selling low, which isn't exactly a prescription for investment success.