Dividends can signify a healthy company, especially when grown consistently over time. Conceptually, they are very simple: a company makes a profit and decides the best use of the money made is to return it to its shareholders. As profits grow over time, in theory, so do the dividend payments and, hopefully, the stock price, keeping the yield steady. Dividends are attractive to equity investors because they are perceived to offer a more certain return than relying on stock price appreciation. Logic would follow, given this, that a higher dividend yield is more attractive than a lower one. This philosophy, when taken to the extreme, will cause some people to do what is called “chasing dividends” or investing in a company solely for a high payout. Despite this perceived added level of safety, excessive dividends can be a sign of trouble, and investing in a security solely because it pays out a large yield can lead to a number of poor outcomes, including poor investment performance and high tax bills.
When a company has a dividend that far outpaces the yield of its peers, it is worth looking into why. An excessively high dividend yield can be a result of poor stock performance, which would likely have a fundamental reason. For example, if a company with a $100 stock price had its earnings fall by 10% and had a proportional decrease in stock price, the stock would trade at $90. If the dividend yield was 10% initially, the yield after the price decline would be 11%. So, while the stock now has a higher yield, the company’s ability to pay the dividend has diminished, which could, over time, lead to the company cutting its dividend. On top of that, investors in the company would have experienced a 10% decrease in the value of their investment.
High-yielding funds may also be dangerous for investors, with perhaps the biggest risk being that investors will not fully understand what they are putting their money into. Many high-yielding funds will employ leverage, utilize complex option strategies, or use other methods beyond just investing in stocks to deliver those yields, which adds risk to the investment inherently but can add even more risk if the investor is not aware of how these strategies work. If you Google a list of the highest yielding ETFs, the top funds to come up will all either be leveraged funds such as the GraniteShares 2x Short NVDA Daily ETF, or option strategy-based funds like the YieldMax COIN Option Income Strategy ETF. Both funds have greatly underperformed the S&P 500 this year despite boasting trailing dividend yields of over 150%, with the GraniteShares 2x Short NVDA Daily ETF having a total return of -93%. Funds may also offer high yields by investing in a pool of stocks that fall into the previously mentioned category of problematic companies. We believe investors should follow the general rule of not investing in what they do not understand. Another risk of investing in funds strictly for yield is sector concentration. Certain sectors, such as utilities, tend to pay out higher dividends than others, and high yielding funds be highly concentrated in these sectors, reducing diversification. Over the long term, this can lead to underperformance versus the broader market if higher yielding sectors underperform.
To be sure, high yields are not always a sign of trouble. They can be a product of regulations, such as in the REIT or BDC spaces, where firms are mandated by law to payout 90% of their profits. They can also happen as one-time payouts of greater than anticipated profits, known as special dividends. Where it becomes a problem is with companies that are seeing artificially high yields due to a depressed stock price, or when a dividend exceeds a company’s ability to pay it consistently. It is important to research an investment before buying into it; otherwise, you may be taking on unforeseen risks, especially when it comes to chasing dividends. Taking on these risks can harm your total return, which, at the end of the day, is more important than a high dividend yield.
Written by: Brian Sawyer
