A new study by Vanguard sheds light on how income investors handle dividends.
Dividends are quarterly payouts that are designed to provide investors with income from their investments, along with capital appreciation or returns.
But a new study from Vanguard shows that most investors in its equity income funds don’t actually take the dividend income – they reinvest it back in the fund.
Vanguard portfolio manager Paula Hill noticed a pattern on dividend distribution days for the (VEIPX) that led her to believe that most investors weren’t taking the dividend income.
“We call the fund Equity Income, and we focus on stocks that offer above-average dividend yields,” Hill, head of the Global & Income Active Equity team within Vanguard Quantitative Equity Group, said. “But on the days the fund distributes dividends, we generally don’t need to raise much capital. Most of the investors reinvest their dividends in the fund.”
This observation sparked a larger analysis within the Vanguard fund family, conducted by Paulo Costa, a senior behavioral economist with Vanguard Investment Strategy Group. The results supported Hill’s observation, as Costa found that most investors automatically reinvested their dividends, across a range of equity income funds.
The survey of some 5,000 investors in Vanguard’s five major dividend and equity income funds, conducted with Meir Statman, a professor of behavioral finance at Santa Clara University, revealed that more than 80% of income investors reinvested their dividends. Only 12% said they needed the dividends provided by these funds.
“We thought, ‘Why would investors own an income fund if they didn’t want the income?’” Hill said. “So, we decided to ask them.”
Why Not Take the Dividend?
The researchers also sought to find out if the behavior of income or dividend investors was different from investors in other, non-income Vanguard funds. It found that investors in these 5 income funds were no more likely to take dividends than investors in other funds were.
Thus, the primary reason for owning income funds was not the income. Most said it was for other reasons, like diversification. Most investors surveyed said they see income funds as core holdings, made up of stocks of more stable companies that are less volatile and “care more about their investors” than those that pay low or no dividends. They provide some ballast in a portfolio compared to more volatile growth funds.
“These results suggest investors derive emotional benefit from investing in dividend-paying stocks, in addition to the more utilitarian, financial benefits,” Costa said.
When asked why they choose to reinvest their dividends, about 80% said it was because of the compounding returns, while 70% said it was because they didn’t need the dividends for immediate spending.
Reinvested Dividends Boost the Return
The benefits of reinvesting the dividends for higher returns are real and significant. Look at the (VEIPX), for example. Over the past five years, it has an average annual return of 6.1% without the dividend reinvested. But with the dividend reinvested, it has a total average five-year annualized return of 14.1%.
While the results of the study may be a bit surprising, Hill reminds investors that equity income investing can work well for different needs.
“Whether an investor needs income and/or simply values the attributes of higher-dividend-paying companies, an active fund that seeks high-quality companies with stable dividend yields may be suitable,” Hill said.