June 23, 2010

Price Return Versus Total Returns

Looking at historic returns is always an “iffy” business.  No matter how great returns may have been in the past, there is absolutely no guarantee that historic returns can be matched in the future.  In our previous post DIAmonds are forever, I suggested an average investor should consider allocating his entire stock portfolio towards one major market index such as the ETF SPDR DIAMONDS TRUST (DIA).  This ETF is a low cost index tracking fund that matches the index components of the Dow Jones Industrial Average.  I also suggested to forget about any additional international diversification on the basis that the vast majority of the companies in the Index derive a substantial part of their income from outside the US. 

Instead of using some fancy quantitative model to gauge the most appropriate international diversification and having to rebalance that exposure at least once a year, just let the companies in the Index determine your international allocation on the basis of finding the best international markets for their products.  That method is easy to understand and equally easy to implement. 

We received a number of inquiries questioning whether the method made any sense considering the poor stock returns during the past decade.  Quite rightly so, the overall market, measured by its benchmark S&P500, is down almost 25% for the decade ending June 22.  Factoring in the dividends, total returns are still negative at about 10% for the decade, but still much better than loosing a quarter of the portfolio.

Source: www.etfreplay.com

Further, let’s not forget that the vast majority of fund managers are not able to outperform the benchmark as has been documented at length; why bother paying those extra fees...

At an expense ratio of 0.18% DIA is among the lowest cost ETFs and it still had an upper hand over many Mutual Funds with active trading strategies and higher fees.  But we looked at DIA as a target index for the following reasons:

Simplicity: The Index is only made up of 30 companies, easy to oversee and to assess in terms of like/dislike and specific company risk.  Compare that to the 500 companies of the S&P 500 or the 2000 companies making up the Russell 2000 Index.  Simplicity is also compelling for a more sophisticated investor.  It is far easier to assess a specific risk or concern with say one of the 30 companies; that risk could then easily be hedged by buying an insurance via a put option against the stock based on the same ratio of the weighting within the Index.

Historic performance: In the end, the numbers speak louder than words.  However you may feel about the Dow not reflecting the entire market, this mother of all indexes has weathered the last few financial storms better than the S&P 500.  It clearly outranked the broader market both in terms of price return as well as overall return.  As a bonus, it did so at a slightly lower volatility i.e. less risk.

Source: www.etfreplay.com

Factoring in Dividends: Dividends may not have played a big role during the roaring 90’s when every investor was purely chasing growth stocks, ignoring any yield from dividends.  During the past decade and particularly since the great recession, the need for sensible yields from stock dividends has made a come back. With regard to overall returns, the yields from the DIA clearly made the difference.  In the case of the past decade, the difference was about 25%, reversing the small negative return substantially towards the upside. 


Source: www.etfreplay.com

As these charts indicate, it is not realistic to just look at a price chart and forget about the impact of dividends on overall returns.  In the case of DIA, dividends were a significant factor in the overall performance throughout this rather volatile decade.  Factoring in dividends towards overall returns for DIA, it wasn’t a lost decade after all.  Overall Return in the past 10 years has not been stellar, but gains are still gains. With the lower cost and slightly lower historic volatility, this ETF is definitely worth considering for an average investor.

Next, we will examine whether a traditional dollar-cost averaging method, i.e. buying a fixed dollar amount of DIA shares each year, could skew the results further to the upside.  Stay tuned...

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1 comment:

Kwillcox said...

What would the returns be if you limited your choices to those DOW stocks that did DRIP, and fully utilized DRIP?