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Thomas Boccellari | March 17, 2017

Avoiding the equity income “dividend trap”

Income-oriented stocks can provide investors with numerous advantages – including the potential for high, recurring income, a possible inflation hedge and added portfolio diversification. And while diversification does not ensure a profit or protect against loss, dividend stocks can serve as a significant source of investment returns. In fact, over the past two decades, dividends have contributed more than 40% to S&P 500 Index investors’ total returns.1

In today’s low interest rate environment, investors are seeking yield anywhere they can, and high-yielding dividend stocks may seem like an ideal solution. But these same investors may inadvertently be wandering into a dividend trap.

Beware “dividend traps”

A dividend becomes a trap when investors are lured by high dividend yields that are misleading or not sustainable. For example, a company’s stock price may be in decline because of financial struggles, which may cause a company’s management to rethink future dividend payments. Dividends are often paid out quarterly, however, and unsuspecting investors can be trapped by taking a position in the stock before the dividend has actually been cut.

The following chart illustrates one such scenario. Note that this Company A’s dividend remains robust for more than a year after the company’s stock price begins falling. During this time, investors lured by the promise of high yields may buy the company’s stock, only to see the dividend slashed.

Dividend trap #1: High dividend and falling share price

Source: Bloomberg L.P., March 10, 2017. For illustrative purposes only. Past performance is no guarantee of future results.

Dividend yields may also appear attractive because the company’s stock price is falling – not because of increased dividend payouts. Dividend yields are calculated as a percentage of a company’s stock price. Thus, when the denominator (stock price) is falling, dividend yields can be artificially inflated. Falling stock prices rarely bode well for future dividends. By taking a position in a volatile issuer with a declining share price, investors may be entering a dividend trap.

In the chart below, note that the dividend yield mirrors Company B’s falling stock price – rising as the company’s share price declines. Note also that the stock’s dividend yield is at its peak just before the company slashes its dividend by 80%, before eliminating it altogether.

Dividend trap #2: Dividend yield peaking before dividend cut

Source: Bloomberg L.P., March 10, 2017. For illustrative purposes only. Past performance is no guarantee of future results.

Avoiding dividend traps

In order to avoid dividend traps, investors may opt for dividend-grower stocks. These are dividend-paying stocks whose issuers have a history of increasing dividends on a regular basis. Even with rising dividends, however, dividend-grower yields aren’t always especially attractive – particularly in a low-yield environment in which the Bloomberg Barclays US Aggregate Bond Index is yielding less than 2.6%.1

Fortunately, we believe there is one way to reduce the possibility of dividend traps without sacrificing yield potential – the addition of a low volatility screen. By using a low volatility screen, investors may be able to generate high current income while avoiding dividend traps that can sink an investor’s portfolio. The chart below shows the 12-month dividend yield and three-year annualized volatility for a variety of dividend strategies. Over this three-year period, the high dividend, low-volatility strategy generated high current income while reducing volatility relative to other dividend strategies and the S&P 500 Index.

Equity dividend strategies compared: Sept. 16, 2012 – Feb. 28, 2017

Source: Bloomberg L.P., as of Feb. 28, 2017. Past performance is no guarantee of future results. High Dividend Low Volatility, High Dividend Grower, Dividend Grower and S&P 500 are represented by the S&P 500 Low Volatility High Dividend Index, S&P 500 High Yield Dividend Aristocrats Index, S&P 500 Dividend Aristocrats Index and S&P 500 Index, respectively. Volatility is represented by standard deviation of monthly total returns. Index performance does not reflect the performance of the PowerShares S&P 500 High Dividend Low Volatility Index ETF (UHD). All data is displayed in U.S. dollars unless otherwise noted.


More from Thomas Boccellari

Avoiding the equity income “dividend trap”
March 17, 2017

The many faces of high yield
February 16, 2016

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1 Source: Bloomberg, L.P., Feb. 29, 2016. Past performance is no guarantee of future results. There can be no guarantee or assurance that companies will declare dividends in the future or that if declared, they will remain at current levels or increase over time.

The Bloomberg Barclays US Aggregate Bond Index is an unmanaged index considered representative of the US investment-grade, fixed-rate bond market.

The S&P 500® Low Volatility High Dividend Index consists of 50 securities traded on the S&P 500® Index that historically have provided high dividend yields and low volatility. An investment cannot be made into an index.

The S&P 500® Dividend Aristocrats Index tracks the performance of 40 companies in the S&P 500®

Index that have had an increase in dividends for 25 consecutive years.

The S&P 500® High Yield Dividend Aristocrats Index is designed to measure the performance of companies within the S&P Composite 1500 Index that have followed a managed-dividends policy of consistently increasing dividends every year for at least 20 years.

Standard deviation measures a portfolio’s range of total returns and identifies the spread of a portfolio’s short-term fluctuations.

Securities that pay high dividends as a group can fall out of favor with the market, causing such companies to underperform companies that do not pay high dividends.

S&P®, S&P 500®, and S&P 500 Low Volatility High Dividend Index™ are trademarks of Standard & Poor’s Financial Services LLC and have been licensed for use by S&P Dow Jones Indices LLC and sublicensed for certain purposes by Invesco Canada Ltd. The S&P 500 Low Volatility High Dividend Index is a product of S&P Dow Jones Indices LLC, and has been licensed for use by Invesco Canada Ltd. Invesco Canada Ltd.'s PowerShares S&P 500 High Dividend Low Volatility Index ETF is not sponsored, endorsed, sold or promoted by S&P Dow Jones Indices LLC or its affiliates and none of S&P Dow Jones Indices LLC or its affiliates make any representation regarding the advisability of investing in such product.

3 responses to “Avoiding the equity income “dividend trap”

  1. Hi Jim/Carey,

    Thanks for your comments. We’ve recently launched two new high dividend, low-volatility ETFs – PowerShares S&P 500 High Dividend Low Volatility Index ETF – CAD (UHD) and PowerShares S&P Global ex. Canada High Dividend Low Volatility Index ETF – CAD (GHD). These are both new to Canada and the performance data is not yet available here in Canada.—cad/at-a-glance/460?lang=en—cad/at-a-glance/458?lang=en

    To your question about low volatility – historically, research has shown a tendency for lower-volatility stocks to outperform the market as a whole over full market cycles. This three-part Q&A with two low-volatility index experts from S&P digs into the low-volatility, how it works and how it’s performed over time.

  2. HHhmm… using volatility as key metric on whether you own a business or not, especially using a relatively short, 3 year time horizon, doesn’t seem prudent to me. Why not simply look at the business fundamentals? This whole low volatility theme everyone is focusing on recently has me concerned.

  3. Good Article with very valid points!!!

    Is there a page 2? What is the conclusion? What have you done to build a better “mousetrap”? What product is this in? By reducing volatility, what have you done to total returns?

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