Why do ASX dividend shares underperform the market?

ASX investors love a good dividend share. But many actually underperform over time. Here’s why, and some proof to back it up

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ASX dividend shares are popular in Australia. The S&P/ASX 200 Index (ASX: XJO) has long been known for its hefty dividend potential, and ASX blue chips that pay out dividends traditionally have a role in most retail investors’ portfolios.

But the evidence is starting to build up that many of the ASX shares that have the largest reputation for being the biggest dividend payers are not market-beating stocks. Let’s take a look at a couple of examples. Westpac Banking Corp (ASX: WBC) is one of ASX’s most popular shares as one of the big four banks. Before the coronavirus pandemic, Westpac shareholders were used to an annual fully franked dividend yield of between 5-8%.

Yet Westpac shares, at their current pricing, have literally gone nowhere for over a decade. You could have bought Westpac shares at the same price as is available at the time of writing, back in March of 2007. Between late May 2008 and today, Rio Tinto Limited (ASX: RIO) shares are up 3.75%. Not a great capital return for 23 years of waiting. Commonwealth Bank of Australia (ASX: CBA) shares were higher in 2015 than they are today. And investors who bought Woodside Petroleum Limited (ASX: WPL) shares back in June 2008 are still down around 60% on their money. And AGL Energy Limited (ASX: AGL) shares are today trading at a level we last saw in 2004.

All of these ASX shares are known as dividend heavyweights. And all have been mediocre long-term performers in terms of share price growth.

Do higher dividends equal lower returns?

Let’s take a look at two ASX exchange-traded funds (ETFs) to see this pattern in action. The Vanguard Australian Shares Index ETF (ASX: VAS) tracks the largest 300 companies on the ASX. It is a simple index fund, holding dividend payers and non-dividend payers alike, going only on market capitalisation.

In contrast, the Vanguard Australian Shares High Yield ETF (ASX: VHY) holds a smaller basket of shares, only holding companies “that have higher forecast dividends relative to other ASX-listed companies”. As you would expect, the VHY fund offers a far higher trailing dividend distribution yield at 3.57%, compared to the broader ASX 300 ETF’s 2.61%.

However, that higher yield does not translate into better overall returns. The ASX 300 ETF has returned an average of 10.25% per annum over the past 5 years. The dividend-focused VHY ETF has returned an average of only 8.99% per annum over the same period.

So why do many ASX dividend shares underperform? Well, that’s a complicated question. But it might have something to do with the fact that paying out dividends weakens a business. A business that shovels most of its earnings out the door has less left to invest in itself, to grow and expand. That might be why some of the companies mentioned above have had their share prices stuck in the proverbial mud for more than a decade.

So if you love a good dividend (and who doesn’t?), keep in mind that you might be sacrificing your overall return if you chase the highest yields possible.

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Motley Fool contributor Sebastian Bowen owns shares of Vanguard Australian Shares High Yield Etf. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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