A Checklist for Assessing Dividend ETFs

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A version of this article appeared in the June 2019 issue of Morningstar ETFInvestor. Download a complimentary copy of Morningstar ETFInvestor by visiting the website 

Exchange-traded products belonging to Morningstar’s “dividend” strategic-beta group form one of the largest contingents within this universe as measured by assets under management. As of the end of May 2019, these funds collectively held $173 billion of investors’ assets.

This group has been growing at a blistering pace in recent years. During the trailing decade, dividend ETPs have attracted nearly $133 billion in new assets.

This should come as little surprise in the context of the prevailing interest-rate regime and the secular upward trend in demand for sources of investment income, as the first waves of baby boomers have entered retirement.

Asset managers have taken notice, and product proliferation is in full swing. Of the 140 dividend ETPs that exist today, just under half are less than five years old. As the menu of dividend ETPs expands, it is important that investors understand that not all dividend ETPs are created equal. Each has its own unique characteristics, which stem from important–albeit often nuanced–differences in the methodologies of their underlying benchmarks. Understanding three key characteristics of these funds can help investors make more-informed choices. These include dividend yield, dividend growth, and dividend durability.

Dividend Yield
A fund’s current dividend yield is often the first metric investors seek out when shopping for equity-income opportunities. The 12-month-yield metric aggregates an ETP’s distributions during the trailing 12 months and then divides that figure by the fund’s net asset value. While this metric is interesting, it is not very useful in isolation, because it lacks context.

Framing a fund’s 12-month yield in the context of its historical values and relative to the current and historical values for comparable strategies provides useful context. For example, Exhibit 2 plots the current, average, maximum, minimum, and 75th and 25th percentiles of the monthly 12-month yields for dividend exchange-traded funds that invest in U.S. large caps and that launched before 2007. It also includes

(A larger version of this chart is available here.)

It is apparent, based on a passing glance at this exhibit, that these funds’ yields can be quite volatile over time. It’s also obvious that they can diverge dramatically from one another. At the end of February 2008, the highest-yielding fund of the lot,

Dividend Growth
Investors too often look at dividend yields in isolation, without giving dividend growth its due. Dividend growth is a vital component of the overall income equation, as it will determine the extent to which the expansion of an investor’s equity-income stream will lag, keep pace with, or outstrip the rate of inflation. The goal, of course, is to grow this income stream at a rate that exceeds inflation, in order to grow one’s real (that is, inflation-adjusted) income.

Of the 10 dividend-oriented ETFs included in the sample, four of them track a benchmark that specifically screens its investable universe for firms with long track records of paying and/or regularly increasing dividends. Isolating firms with a long track record of paying and increasing dividend payments is a backdoor quality strategy. These companies tend to be less cyclical and more profitable than most and have healthy balance sheets. In Morningstar parlance, they often have economic moats—durable competitive advantages that allow them to earn juicy profits for extended periods. These firms are often well-positioned to increase dividends over time and will, on average, fare better than the market at large during downturns.

Dividend Durability
Perhaps even more important than dividend growth is the overall stability of the dividend income stream. After all, investors looking to these funds as a source of cash flow would be disappointed to find that their income stream is volatile and may be devastated if they were to take a substantial pay cut.

The financial crisis provided a test case for these ETFs, putting the dividends of the stocks they owned under extreme pressure. For each of the funds in my sample, I calculated what I’ll refer to as their maximum dividend drawdown: the largest year-on-year decline in their annual dividend payment. Unsurprisingly, all four ETFs whose benchmarks specifically screen their constituents based on a steady history of paying and growing dividends had, on average, relatively muted dividend drawdowns. Much like dividend growth, the durability of firms’ dividends speaks to the quality of their franchises, the consistency of their cash flows, and thus, their ability to continue to return cash to their shareholders in the form of dividends even in the trough of an economic cycle.

Putting It All Together
Exhibit 4 puts it all together. The ETFs included are the same as those referenced above. This includes dividend ETFs that invest in U.S. large caps and were launched prior to 2007. It also includes SPY as a point of reference. In the exhibit, I’ve listed these funds’ 12-month yields as of the end of May 2019, the maximum year-on-year drawdown of their annual dividend, the trailing three- and five-year compounded annualized growth of their dividends, and their expense ratios. The composite score in the far righthand column is a simple sum with a maximum value of 5. If an ETF has an above-average current yield, a below-average maximum dividend drawdown, above-average dividend growth during the trailing three- and/or five-year periods, or a below-average fee, it earns a point. I ranked the ETFs in this group by their composite scores.

This ranking is a back-of-the-envelope assessment. It is not meant to be a comprehensive list of best-of-breed funds—especially as it excludes many newer entrants that also dabble in U.S. large caps. It provides a useful guide for conducting your own due diligence. Investors scrutinizing dividend ETFs should consider the following:

1 | Price Fees are the most stable, explicit, and predictable detractor from future performance and will come directly off the top of an investor’s income stream. Look for low-cost funds.

2 | Yield Do not consider yield in isolation. Rather consider it in its historical context, how it stacks up relative to peers, and how it springs forth from the underlying index methodology.

3 | Growth Look for funds that can grow their dividends at an inflation-plus rate over the long haul. Benchmarks that specifically screen for historical and/or prospective growth should have better odds of growing their income streams over time.

4 | Stability Investors should place a premium on income stability, particularly in bear markets. On average, the ETFs in the sample I studied that specifically screen for growing and/or stable dividends fared better during the financial crisis, experiencing relatively muted dividend drawdowns versus their peers. VIG, which carries a Morningstar Analyst Rating of Gold, fits this mold.

 

 

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.




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