Dogs Of The Dow Review: Is It A Winning Strategy?

I’ve heard of the Dogs of the Dow strategy for as long as I’ve been interested with investing.

The Dogs of the Dow strategy was initially described in 1991 by John O’Higgins in the book Beating the Dow: A High-Return, Low-Risk Method for Investing in the Dow Jones Industrial Stocks with as Little as $5,000.

It has captured the imagination of millions of investors not only because of its catchy name but also because of its simplicity.

But more than 25 years after its introduction, is the Dogs of the Dow still a relevant investment strategy in 2018?

The Dogs of the Dow Strategy

To execute the Dogs of the Dow strategy, you need to purchase the ten stocks with the highest dividend yield at the end of the previous year in equal proportions. You then hold the stocks for the year and replace them with the new Dogs of the Dow for the following year (rebalancing to make sure you have the same amount of money in each stock).

Here is the list of the ten Dogs of the Dow holdings for 2018, according to DogsOfTheDow.com:

Combined, the ten Dogs of the Dow stocks for 2018 have a dividend yield of 3.47%, significantly higher than the S&P 500’s dividend yield of around 2%.

Historical Returns of the Dogs of the Dow Strategy

Using approximate annual return data (stock return + dividend yield from previous year) from DogsOfTheDow.com, a website dedicated to the strategy, here is a chart of how $10,000 would have grown using the Dogs of the Dow strategy compared with the Total Stock Market Index (using data from Portfolio Visualizer)

Data Sources: DogsOfTheDow.com, Portfolio Visualizer

The average annualized return of the Dogs of the Dow strategy from 1996-2016 is approximately 9.1%, compared with 8.4% for the Total Stock Market Index.

Dogs of the Dow Exchange-Traded Note (ETN)

You can invest in an exchange-traded note (ETN) that follows the Dogs of the Dow strategy. The ticker is DOD. The note is thinly traded (<10,000 shares a day), and has an expense ratio of 0.75% — a very high expense ratio given that the strategy could be managed like an index fund.

Criticisms of the Dogs of the Dow Strategy

Requires rotation of stocks every year

There are changes every year in the ten Dogs of the Dow stocks — that means that you are going to have to make trades. The purest form of the strategy involves switching out the Dogs of the Dow stocks and rebalancing your portfolio at the close of each calendar year.

As a result, you could trigger short-term capital gains for shares held less than 1 year. Even if a stock has been in the Dogs of the Dow list for several years, you will still have to eventually pay long-term capital gains in taxable accounts when it gets removed from the list. This lowers your returns because those capital gains get sent to the government instead of continuing to grow in your account.

Higher dividend income in taxable account = higher taxes

Dividends are very popular for some investors, but unfortunately these dividends are taxed in taxable accounts. For high-income professionals in the top tax brackets, this could mean that a lot of this money is lost to taxes if the Dogs of the Dow strategy is implemented in a taxable account.

Is the Dogs of the Dow diversified?

Ten stocks is generally considered too few stocks to have a diversified portfolio.

For example, tech stocks generally pay lower yields than the typical stock, and the Dow Jones Industrial Average did not contain any tech stocks in the late 1990s. Not surprisingly, the Dow Jones Industrial Average significantly underperformed the S&P 500, which did contain technology stocks, in the late 1990s.

In addition, because they are in the Dow Jones Industrial Average, it consists of large-cap stocks. It can be helpful to hold small-cap as well as large-cap stocks in your portfolio.

All that being said, there is still a high correlation between the performance of the Dogs of the Dow strategy and the total stock market index when you look at the performance chart above.

There are other ways to hold a high-dividend portfolio

The Dogs of the Dow originated before there was widespread adoption of index funds and before the age of ETFs. These days, you can purchase index ETFs that have very low expense ratios, and provide more diversification than the Dogs of the Dow strategy.

If you want a pure high-dividend index ETF, you can purchase Vanguard High Dividend Yield ETF (VYM) or iShares Core High Dividend ETF (HDV). Both of these ETFs have an expense ratio of 0.08%, so it’s easy to own a high-dividend, low-cost index portfolio that is more diversified than the Dogs of the Dow strategy.

Is the Dogs of the Dow a stealth value play?

The Dogs of the Dow strategy could potentially be considered a bet on value stocks. The dividend yield is based on the current stock price divided by its past 12 months of dividends. If a stock falls, than the dividend yield will rise, as most companies in the Dow Jones index are unlikely to significantly cut their dividend even if their stock were to fall.

Conversely, stocks that have risen will have their dividend yields decline. Companies usually increase their dividends at a steady rate, rather than trying to keep their dividend yields stable.

Therefore, many stocks that enter the Dogs of the Dow list end up being the poorest performers of the previous year, potentially making them undervalued using traditional fundamental analysis metrics. According to the Nobel Prize-winning Fama-French model, value stocks were considered to be one of the factors associated with higher historical returns.

If the Dogs of the Dow is simply a play on value stocks, there are other ETFs that can give you exposure to value stocks while being more diversified than holding just 10 large-cap stocks. For example, you could invest in Vanguard Value Index ETF (VTV) (ER = 0.06%) and iShares Core S&P U.S. Value ETF (IUSV) (ER = 0.05%).

Conclusion

The Dogs of the Dow strategy is a trading strategy designed for dividend-loving investors or investors looking for a creative way to play value stocks. However, I think in 2018, there are better ways to invest in dividend stocks or value stocks than the Dogs of the Dow strategy. I don’t personally tilt my portfolio towards dividend stocks or value stocks, but if I did, I would use Vanguard or iShares ETFs.

What do you think? Do you invest in the Dogs of the Dow strategy? Do you think the strategy will outperform the broader stock market in the future?