Income Over Capital

Using the inflation-adjusted S&P composite index (a blend of the S&P 500, which dates from 1937, with earlier S&P indices and stock market data from the universities of Chicago and Yale) as a benchmark for US equity prices, the website shows that the long-term real growth rate in equity prices has been 1.7% per annum. On top of this, real (inflation-adjusted) dividends have grown at an average annual rate of 1.08%.

But the third component, the dividend yield itself, turns out to be the most important contributor to an investor’s long-term return. Yields, though, have been cut in half when the last 27 years (1983-2010) are compared with the previous 112 (1871-1982). The average equity dividend yield since the beginning of the 1982 bull market is only 2.52%, whereas for the century before it was around 5%.

It’s worth noting on the first chart that the 2008/09 equity market collapse caused dividend yields to rise towards the long-term average, but the recovery in share prices since then has brought them right back down again: the S&P 500 index’s dividend yield is now back below 2%.

Other factors are at play here too. US companies’ dividend payout ratio (the proportion of earnings paid out in dividends) has declined over the last few decades, as companies have chosen to retain earnings rather than to pay them out, often spending them on stock buybacks or acquisitions. By the end of the five-year bull market ending in 2007, the payout ratio had fallen to a record low of 31%, according to Yale’s Robert Shiller. Between 1940 and 1980, by contrast, the payout ratio averaged over 50%.

In another sense, nothing’s really new in the neglect of dividends that we’ve observed over the last couple of decades, a trend that has been particularly evident in the US market. Writing a few years after the Wall Street crash of 1929, John Maynard Keynes observed that: “It is rare, one is told, for an American to invest, as many Englishmen still do, ‘for income’; and he will not readily purchase an investment except in the hope of capital appreciation.” He goes on later (in his “General Theory”) to add that “it is said that, when Wall Street is active, at least a half of the purchases or sales of investments are entered upon with an intention on the part of the speculator to reverse them the same day” (Keynes’s italics). Sound familiar?

However, with many major equity benchmarks worldwide either stagnant or down in price over the last decade, the importance of equity income is becoming ever more apparent to investors. The lack of capital gains is also causing people to look increasingly critically at the large proportion of their returns (up to 95%, in some cases, on a ten-year view) that is being swallowed by fund managers in fees.

Losing some of the full dividend stream from the underlying shares when you invest via a pooled fund is potentially a major concern, as we pointed out in a recent article (“Those Leaky Dividends”). While not an ETF-specific problem, it’s one that’s more acute for exchange-traded funds given that their key selling point is their low cost. After all, 20-30% of equity income forgone as a result of dividend taxation (when your ETF benchmark assumes that this is all you get) is a big deal over the long term, given what the charts above illustrate.

Whether and to what extent this dividend leakage can be offset by ETF issuers, either through choice of fund domicile, better use of double taxation treaties, or securities lending, is a subject that deserves a great deal more debate, in my opinion.

But it’s also worth remembering Keynes’s broader conclusion when weighing up equity dividend income and potential capital gains.

“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

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