The decades-old strategy, which calls for buying the 10 highest-yielding shares among the 30 Dow Jones Industrial Average members at the end of each year, has returned 5.5% this year through Wednesday, versus a 0.4% decline for the broader Dow.
The dogs have had long periods of outperformance. From 1961 through 1998 they beat the Dow by 1.7 percentage points a year, according to a University of Kansas study. However, the same study found that, net of trading costs and taxes, there wasn't much point in using the dogs approach.
More recently, the dogs have lost their bite, lagging behind the Dow in 10 of the past 15 years.
Despite its shortcomings -- such as a tendency to produce poor diversification -- the strategy is based on an excellent idea: rules-based value investing. Today, a number of exchange-traded funds improve upon the dogs approach, seeking a performance edge with increased safety. There is reason to believe such funds will make solid core holdings in coming years.
Value stocks are those that look cheaper than others relative to some fundamental measure of worth, such as earnings, book value or dividend payments. A vast body of research suggests that value stocks outperform over long periods. Savita Subramanian, head of U.S. equity strategy for Bank of America Merrill Lynch, says valuation is the most important predictor of long-term returns -- as opposed to other factors, such as growth projections and Wall Street "buy" recommendations.
The problem: Cheap stocks are often ugly, too. Why else would the herd have left them cheap? For most investors, it isn't easy to scoop up unpopular shares, no matter what the long-term evidence says.
That is where rules come in. The dogs strategy takes investor bias out of the process, and it makes yearly portfolio rebalancing faster than an oil change.
But it also leaves investors highly dependant on just a handful of stocks, and it doesn't screen for financial strength. That is a liability in an era when even a Dow member can go bust, as General Motors (GM: 21.59, 0.31, 1.46%) did in 2009.
Like other untamed value approaches, the dogs strategy also can produce lopsided sector bets. In 2007, the portfolio included two banks, Citigroup (C: 29.83, 1.66, 5.89%) and J.P. Morgan Chase (JPM: 33.51, 1.18, 3.65%), plus two manufacturers that had grown heavily dependent on making loans, GM and General Electric (GE: 16.33, 0.24, 1.49%).
No wonder the 2008 and 2009 financial crisis was a lousy period for dogs' investors. It is less troubling that the dogs sharply underperformed during the late 1990s, which in hindsight looks like an aberrational stretch of bloated valuations during which a lot of prudent strategies fared poorly.
One way to adopt a better-behaved dogs strategy is through exchange-traded funds that run periodic screens for high dividend yields. They offer exposure to hundreds of stocks instead of just 10, while keeping expenses reasonable. And their current yields compare favorably with the 10-year Treasury yield of about 2%.
"The baby boomers will be retiring over the next two decades starting this year," says Jeremy Schwartz, director of research at Wisdom Tree, an investment firm. "They're going to want investment income, which means dividend-paying stocks will be in strong demand."
The Wisdom Tree Equity Income ETF is a dogs lookalike, but with more than 300 stocks. Health-care and consumer staples firms have the heaviest portfolio weightings, at 19% apiece. The fund has returned 2.2% from its June 2006 inception through the end of October, double the return of its benchmark, the Russell 1000. It costs $28 a year per $10,000 invested and yields 4.1%, based on trailing 12-month dividend payments.
Vanguard High Dividend Yield is a similar ETF but with more than 400 stocks and a lower yield, 3.1%. Consumer staples are 20% of the portfolio and industrial firms are 15%. And this dogs alternative keeps fees on a leash, at $18 a year per $10,000 invested.
Finally, the SPDR S&P International Dividend ETF offers overseas dogs exposure. Australia, the United Kingdom and Germany together make up just over one-third of the portfolio, and telecoms and utilities together have a 47% weighting. Recent declines in European stock markets have left the fund with a dividend yield of more than 7%. Expenses are $45 a year per $10,000 invested.
These funds won't beat their benchmarks every year, of course. But if the original dogs philosophy has merit, these new breeds might fetch more reliable results.