The Irrelevance of Dividend Investing
When it comes to building a long-term investment portfolio, many investors are drawn to dividend-paying stocks for their perceived stability and income generation. But is focusing on dividends the best way to invest for future returns?
Recent research and practical implementation suggest otherwise. Let’s explore why a high profitability strategy—such as the one used by the Dimensional U.S. High Profitability ETF—may be a better approach than traditional dividend investing, such as the strategy used by the NOBL S&P 500 Dividend Aristocrats ETF.
Comparing Strategies: Dividends vs. Profitability
Both NOBL and Dimensional’s ETF operate within the large-cap U.S. equity space and share many overlapping holdings. But their selection criteria differ significantly:
NOBL selects companies that have increased dividends for at least 25 consecutive years.
Dimensional’s ETF selects companies with high profitability, typically measured by operating profits over book equity.
While dividend strategies like NOBL tend to overweight sectors such as consumer staples and utilities (which traditionally pay reliable dividends), Dimensional’s strategy limits sector drift to 10%, helping avoid overexposure to specific sectors. This reduces idiosyncratic sector risk, which is not compensated with higher expected returns (Sharpe 1991).
Do Dividends Predict Higher Returns?
Although dividend-paying stocks are popular, there is little evidence to suggest that dividend yield alone predicts superior future returns.
Academic research, notably by Fama and French, shows that dividend yield has no statistically significant alpha when controlling for other factors like market beta, size, and value (Fama and French 2001; 2015). In other words, the returns of dividend strategies can be fully explained by their exposure to other risk factors—dividends don’t provide an additional edge.
Companies that reinvest earnings into profitable projects often achieve better long-term compounding. In fact, high profitability itself has been shown to be a strong predictor of excess returns (Novy-Marx 2013).
Tax Efficiency: Another Hidden Advantage
Taxes matter—especially in taxable accounts. Dividends are typically taxed in the year they’re received, which can lead to a higher ongoing tax burden. In contrast, investors in non-dividend-paying stocks can defer taxes until they choose to sell, providing greater control over taxable events and potentially improving after-tax returns (Poterba and Summers 1985).
Because Dimensional’s profitability strategy favors companies that reinvest earnings rather than pay them out, it tends to be more tax-efficient over time.
Avoiding Unnecessary Sector Bets
One of the key drawbacks of dividend-focused strategies is their unintentional sector bias. Since certain industries (like utilities and consumer staples) have more companies that pay steady dividends, these sectors become overrepresented, increasing concentration risk. These sector tilts are not compensated for with higher returns and may add unnecessary volatility.
Dimensional’s strategy manages this by capping sector drift and selecting stocks based on characteristics—like profitability—that are more evenly distributed across industries.
Final Thoughts: Profitability Is the More Robust Factor
While dividend investing may appeal to those seeking stable income, the evidence suggests that a focus on high profitability offers a more reliable path to strong long-term returns, with fewer uncompensated risks and greater tax efficiency.
The takeaway: If you’re building a portfolio based on sound, research-backed principles, a high profitability factor strategy may serve you better than simply chasing dividend yields.
References
Fama, Eugene F., and Kenneth R. French. “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?” Journal of Financial Economics 60, no. 1 (2001): 3–43. https://doi.org/10.1016/S0304-405X(01)00038-1.
Fama, Eugene F., and Kenneth R. French. “A Five-Factor Asset Pricing Model.” Journal of Financial Economics 116, no. 1 (2015): 1–22. https://doi.org/10.1016/j.jfineco.2014.10.010.
Novy-Marx, Robert. “The Other Side of Value: The Gross Profitability Premium.” Journal of Financial Economics 108, no. 1 (2013): 1–28. https://doi.org/10.1016/j.jfineco.2013.01.003.
Poterba, James M., and Lawrence H. Summers. “The Economic Effects of Dividend Taxation.” In Recent Advances in Corporate Finance, edited by Edward I. Altman and Marti G. Subrahmanyam, 227–84. Homewood, IL: Richard D. Irwin, 1985.
Sharpe, William F. “The Arithmetic of Active Management.” Financial Analysts Journal 47, no. 1 (1991): 7–9. https://doi.org/10.2469/faj.v47.n1.7.