Every year the dividend season comes around again, and each time there is a hail of facts, half-truths, myths and irrelevancies. It's time for investors to sort out the confusion, says Ali Masarwah, fund analyst and managing director of the financial services provider envestor.
22 April 2024. FRANKFURT (envestor). Last week, just in time for the start of the dividend season, the dividend study of the Deutsche Schutzvereinigung für Wertpapierbesitz (DSW) was published. It always makes the same headlines: great dividends! According to the annual study, dividend payouts break records time and time again. This year, the companies in the DAX, MDAX and SDAX are paying out 62.5 billion euros - the third record in a row. Fund companies also like to emphasize the distributions paid out by their dividend funds. Germany's largest equity fund, DWS Top Dividende, recently paid out 630 million euros, also a record. We would like to summarize what dividends mean for fund investors in five theses.
1. Dividends are an important but variable component of share returns
A DAX without dividends would be even less than the proverbial salt in the soup. The performance of Germany's leading index comes from the combination of dividends and share price increases (also known as total return, or TR for short). Over the past 20 years, the DAX has risen by 347 percent. If dividends were not included in the calculation, the DAX would only have risen by 145 percent. This return was achieved by the so-called price index (PR). The difference is due to the compound interest effect. The retention of dividends, known as compounding, is an important recipe for success in equity investment.
However, the importance of dividends varies depending on the region and sector. While dividends are of crucial importance for the DAX, this is different for the Nasdaq. Price increases are decisive here. The Nasdaq 100 including dividends has risen by 1,338 percent over the past 20 years. Without dividends it was 1,103 percent. That is more than three times as much as the DAX has achieved including dividends. The DAX is dominated by old-economy sectors such as cars, chemicals, financial services and real estate. The Nasdaq is the growth market par excellence. It is home to the major tech platforms such as Apple, Alphabet, Meta, Microsoft and Nvidia. Investing in growth portfolios often leads to investment success without dividends.
2. The performance calculation for funds has special pitfalls
There is an important difference between funds and indices when calculating returns. For distributing funds, the performance calculation also assumes that the distributions are immediately reinvested, even if they actually end up with the investor (this is also referred to as the BVI method). Investors in distributing funds therefore achieve a lower return than the official performance presentation would have you believe, but receive the distributions in return.
Applied to the DAX, investors would have achieved a price increase of 145 percent over the past 20 years with ongoing dividends, but would have seen a performance of 347 percent in the return calculation. Fund investors therefore have the bird in the hand, but could be misled by the performance calculation into thinking that the pigeon is also luring on the roof. Let us note that investors cannot collect fund distributions and enjoy a total return at the same time.
Let's take a look at the DWS Top Dividende: The distributing fund has achieved a plus of just under five percent per year over the past five years. With an annual distribution yield of around 3.5 percent, this means that the fund has in fact achieved a price gain of just under 1.5 percent per year. Those who have been paying out the fund distributions may have been enriched by enjoyable experiences, but the fund has not contributed to long-term wealth creation; indeed, it has not even compensated for inflation.
3. More dividend often means less fund performance
The above comparison between the DAX and the Nasdaq has already made this clear: Dividends are important for stock returns, but the reverse conclusion that more dividends bring a higher total return is not compelling. In fact, the opposite has been true over the past 20 years. Accordingly, investors should critically scrutinize the category of dividend funds. Their aim is usually to maximize fund distributions.
If you only look at the dividends or the resulting fund distributions, you risk putting together a portfolio of low-growth companies. Companies that distribute most or even all of their profits invest less than growth companies. Leaving growth companies out of the portfolio has been disastrous for returns in recent decades. In view of the AI revolution and the immense technological progress of our time, this will presumably continue to be the case. The danger of underperforming with equities over the long term is the biggest risk investors can take.
4. Because dividends are not interest, dividend funds are not a substitute for bonds
The dividend or payout yield is a very poor measure for selecting an equity fund or ETF because it creates false associations with bonds. For bond investors who hold their securities to maturity, the yield is largely identical to the performance. A classic bond delivers constant coupons, and at the end of the investment, the bond - "the 100" - is usually repaid in full. Investors can use interest income to generate fairly good, because suitable and at the same time predictable distribution profiles.
The situation is different with shares: here the price risk is so high that the dividend yield says nothing about the repayment of the investment sum. In times of crisis, shares can plummet by 30, 40, 50 percent and more, and it can take decades to recover the losses. Against this backdrop, the splendor of DAX payouts fades. The dividend yield on Germany's leading index is currently just 2.5 percent. This corresponds to the yield on ten-year German government bonds. Considering that around 60 percent of the DAX is made up of volatile cyclical sectors (cars, banks, industry, chemicals, real estate), this illustrates how nonsensical headlines such as "Dividends are the new interest" are.
5. Solid payout plans are needed in the consumption phase, not dividend funds
Anyone who needs to withdraw regular income from their fund portfolio should take a look at bond funds. They fulfill the function that investors need in the consumption phase. Interest rates are back, and there is no reason why investors should rely on dividend funds for regular income, especially as they run the risk of triggering a negative compound interest effect in the event of a correction. Then the money is gone faster than you can say goodbye to dividends.
Investors can set up a free payout plan on any fund, at least with investor-friendly financial service providers. If possible, distributions should be made with low-risk funds and generated with the total return (TR). Low-volatility short-duration bond funds currently offer optimal distributions. In view of the inverted yield curve, these funds currently offer the most attractive returns. Should this change, "conventional" bond funds will come into play.
By Ali Masarwah, 22 April 2024, © envestor.de
Ali Masarwah is a fund analyst and managing director of envestor.de, one of the few fund platforms that pays cashbacks on fund sales fees. Masarwah has been analyzing markets, funds and ETFs for over 20 years, most recently as an analyst at the research house Morningstar. His expertise is also valued by numerous financial media in German-speaking countries.
This article reflects the opinion of the author and not that of the editorial team of boerse-frankfurt.de. Its content is the sole responsibility of the author.
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