Most portfolios have taken hits over the past five weeks. The S&P 500 Index was down 3.1% in May and was down an additional 0.5% thus far in June. And many individual stocks and actively managed equity funds have sustained even bigger declines because of the recent selloffs. Can you expect additional corrections this year? More importantly, how can you defend yourself from this kind of volatility? If you have not already done so, be sure to include "dividend indices" and "value indices" in your portfolio. In fact, this may be a good time to buy these specialized indices. They make excellent additions to your portfolio in volatile times. A "dividend index" is an index of the 50 to 100 highest dividend-yielding stocks. A "value index" is essentially a basket of equities having lower-than-average prices as determined by their price-to-book and price-to-earnings ratios. "Value" stocks are deemed to be reasonably priced vis-a-vis real earnings. By comparison, "growth" stocks trade at higher multiples to earnings. Although value stocks and value indices focus on attractive pricing relative to actual earnings being achieved now, growth stocks and growth indices focus on "future potential." Here is a picture of how several different index funds and exchange-traded funds have fared thus far in 2006.
All of these index funds sustained losses over the last thirty days -- corrections in the range of 2% to 5%. But the indices focused on dividend payers and/or value stocks had lower corrections. In fact, the iShares Dow Jones Dividend Index ( DVY) actually had positive trailing one-month results as of Friday's close. Both the dividend and value indices -- DVY and ( VIVAX) Vanguard Value Index fund -- have also produced higher year-to-date returns and higher annualized three-year returns than conventional index funds. Clearly, investing for value and dividends is not failsafe: Each of these indices incurred significant losses -- at least 20% -- in 2002 when the stock market underwent a massive correction. But this investing style has long-term performance advantages. According to Standard & Poor's, the shares of companies that do not pay dividends in the S&P 500 were down 4.67% during the month of May. The stocks of companies that do pay dividends, however, were down 2.37% during the same period. That's a substantial difference. Lesson one: It's better to hold dividend-payers and intrinsic value.
|Ports in a Storm |
Value and dividend indexes hold up better in down markets.
|Symbol||Fund or ETF||Performance|
|1 Month||YTD||12 Months||3 Years Annualized|
|vfinx||Vanguard 500 Index||-4.48%||2.02%||7.38%||10.37%|
|fsmkx||Fidelity Spartan 500 Index||-4.47%||2.06%||7.47%||10.41%|
|vtsmx||Vanguard Total Stock Market Index||-5.08%||2.45%||9.03%||12.06%|
|dvy||iShares Dow Jones Dividend Index||-2.34%||3.94%||5.65%||NA|
|vivax||Vanguard Value Index Fund||-3.39%||5.24%||11.69%||14.15%|
There is also substantial academic research confirming that equity indices tend to outperform actively-managed funds over the long term. Research by Wharton Professor Jeremy Siegel and investment guru Rob Arnott shows that indices of stocks with low price-to-earnings ratios and/or high dividends produce even higher returns than conventional indices. Arnott specifically found that while conventional indices produced an average "geometric" return of 10.35% between 1962 and 2004, indices structured on the basis of dividends, book value, or even sales -- among other kinds of index weightings -- performed substantially better. Over a long period of time, in fact, the specialized or "alternative" indices constructed on the basis of dividends or superior price-to-earnings produced returns that were more than 2% per annum better on average than conventional index performance. And conventional indices, I must reiterate, performed better than 75% to 80% of all actively managed equity funds. Bottom line: Indices of dividend-paying stocks and of "value" stocks often do a better job of shielding you from market volatility, and they deliver superior long-term returns. When you focus on dividends and "fundamental value" rather than capital gains or speculative expectations, you sustain less pain when the market corrects. That was the clear case in May and year-to-date-June. And it's an important lesson worth remembering going forward because there is still some fat built into prevailing stock prices. The stock market's historic price-to-earnings ratio has been 14.6 to 15 vs. the current P/E of 17 to 18. Since the P/E will revert to its historic mean, additional corrections are likely. Count on it, and prepare for it.