Financial Jungle recently wrote about a study put out by Tweedy Browne that purports to show the clear superiority of investing in high dividend yield stocks. One of the examples quoted in the Tweedy Browne study is the Dogs of the Dow.
Constructing the Dogs of the Dow is simple – after sorting the stocks in the Dow Jones Industrial Average (DJIA) by their dividend yields, pick the top ten stocks and invest equal amounts in each stock. Next year, construct a new list and repeat the process again. In Beating the Dow published in 1991, authors O’Higgins and J. Downs calculate that the Dogs strategy would have returned 17.9% annually, compared to 13.0% for the DJIA for the 1973 to 1998 time period.
Did the Dogs of the Dow actually outperform simply buying and holding the DJIA by a massive 5% per year? The answer, it turns out, depends on who does the measuring. In a paper titled, The “Dogs of the Dow” Myth, author Mark Hirschey of the University of Kansas, calculates the returns for the same time period and comes up with an annual return of 15.3%, 2.6% less than the O’Higgins numbers cited in the Tweedy Browne study, for the same time period!
The outperformance also depends on the time period under consideration. While there is still a 2.3% outperformance for the 1973-98 time period, Hirschey find that the outperformance for the 1961-98 time period is only 1.55%.
The excess returns discussed thus far do not account for the excess trading costs (in the past trading costs were significant) and turnover compared to simply buying-and-holding the thirty stocks in the DJIA because the Dogs portfolio needs to be rebalanced every year to sell the stocks that aren’t Dogs anymore, buy the new Dogs and rebalance the existing Dogs to equal weights. If held in a taxable account, the excess turnover in a Dow Dogs portfolio would create an additional drag in the form of taxes. Hirschey estimates these excess costs and concludes:
Thus, implementation of a Dow Dog investment strategy results in added annual brokerage costs of 0.34%, plus added income taxes on dividends of 0.74%, plus added capital gains taxes of 0.50% — or 1.58% in annual transactions costs. These transaction costs are roughly equivalent to the previously unexplained excess returns of 1.55% per year for the Dow Dog strategy over the 1961-98 period.
In a future post, we’ll take a look at the High Yield, Low Payout paper quoted in the Tweedy Browne study.