Investors Shed Dividend-Paying Stock Funds

Investors Shed Dividend-Paying Stock Funds

URRAY COLEMAN

Jan. 29, 2014 3:44 p.m. ET

As the U.S. Federal Reserve trims its purchases of bonds and expectations of higher interest rates grow, investors are pulling billions of dollars from funds focused on dividend-paying stocks.

Instead of prizing the funds as a complement to bonds as they did when long-term interest rates were flatlining, investors are starting to rotate away, in some instances to alternative funds using hybrid stock and fixed-income strategies.

It’s a change in tactics that many investment advisers have been calling for since last summer’s steep rates jump, which came after markets became jittery about signals of an unwinding of the Fed’s economic stimulus efforts.

Still, portfolio managers warn that as rates go up over the next several years, it would be a mistake for investors to abandon all types of dividend-paying stocks.

“Even in a time of rising interest rates, some companies are financially sound enough to keep producing higher rates of dividend growth,” said Michael Jones, chief investment officer at RiverFront Investment Group, which manages about $4.2 billion in assets.

Since mid-November, investors have pulled nearly $3 billion net from dividend-paying mutual funds and exchange-traded funds, according to fund tracker Lipper. That comes after the group attracted more than $79 billion over a three-year period through 2013.

“With the Fed moving to taper its bond-buying program and rising expectations of higher interest rates, fund investors’ appetites for income-focused equity funds have dropped considerably,” said Jeff Tjornehoj, Lipper’s head of Americas research.

The extra income that high-dividend stocks are generating relative to other parts of the market has fallen as the stock market has rebounded from its lows after the 2008-09 financial crisis. As prices rise, yields fall.

In early 2009, the 50 highest-paying stocks in the S&P 500 index averaged yields about 7.6 percentage points greater than 10-year Treasurys, according to Bank of America Merrill Lynch. The top 50 dividend payers in the S&P 500 now have a less-than two-percentage-point average spread over benchmark Treasurys, Merrill Lynch estimates.

As a result, the argument for remaining in dividend-paying stocks has shifted from their value solely as an income-producing investment to their potential for future dividend growth.

Still, many investors remain focused on the highest-yielding stocks, according to Charles Blankley, chief investment officer at Gemmer Asset Management in Walnut Creek, Calif., with $810 million in assets.

“The tide is turning, but a lot of people still are reaching for yield at the sake of investing in funds that concentrate on businesses that can hold up better in a rising rate environment,” he said.

To get exposure to companies with strong cash flows to support future dividend growth, he suggests investors consider the Vanguard Dividend Appreciation ETF (VIG). For those who prefer actively managed mutual funds, Gemmer’s managers recommend the Oakmark Equity & Income Fund (OAKBX).

“In a world where interest rates are held artificially low, high-dividend-paying stocks can command premium valuations. But times are changing,” Mr. Blankley said.

The median price-earnings ratio of blue-chip companies that are increasing dividends by 50% or more annually is 15.6, based on expected 12-month earnings, according to Merrill Lynch. That’s in line with its average since 1990.

By contrast, the highest-yielding blue-chip stocks are trading at similar multiples, but about 25% higher than their long-term averages. “Our view is that people aren’t giving enough attention to the power of dividend growth,” said Dan Suzuki, a Merrill Lynch equities analyst.

Companies emphasizing dividend growth as part of their business strategies and showing lower exposure to market volatility should return about 7% a year on average over the next decade, according to a new forecast by RiverFront Investment. The study, which tracked performances for both types of stocks over the past 85 years, predicts that the highest-yielding stocks will return about half as much in that same period.

In client accounts, Mr. Jones favors the WisdomTree LargeCap Dividend Fund (DLN). “It tends to give much more importance to companies that don’t have the absolute highest yields, but have an ability to keep growing their dividends,” he said, noting that the fund’s top holdings are Apple Inc. (AAPL) and Exxon Mobil Corp. (XOM).

Since higher interest rates indicate that economic growth should continue, now is a good time for investors to rotate out of funds emphasizing the highest dividend payers, said Mark Eshman, chief investment officer at ClearRock Capital in Ketchum, Idaho, which manages $400 million.

In client accounts, he has been favoring the iShares High Dividend ETF HDV -1.05%(HDV) and the iShares International Select Dividend ETF IDV -1.14% (IDV).

“We still see these ETFs as a good way to enhance a portfolio’s income, but we’re steering clear of high-dividend-paying funds that look more like proxies for bonds than stocks,” Mr. Eshman said.