By Michael Rawson, CFA
Dividend-focused exchange-traded funds that offer a decent yield
and instant diversification have been wildly popular in recent
years, thanks to the paltry yields in fixed income. To satisfy
investor demand, ETF providers have launched a slew of new
products. Many of these
offer more intelligent designs than the first generation of
dividend-focused ETFs. The improvement in structure is in response
to some flaws in some of these older ETFs. Here we will discuss
some of these flaws and highlight the new ETFs that we like.
According to data from Ken French's website, dividend payers
have outperformed nonpayers over the past 85 years. If we sort the
dividend payers into five quintiles, we find that the
highest-yielding bucket, quintile 5, does not have the highest
return or highest risk-adjusted return--that distinction belongs to
quintile 4. In other words, reaching too far for yield can lead to
suboptimal results. This suggests that, with appropriate screening,
we can build a better dividend fund than one that naively buys just
the highest-yielding stocks.
In the current economic environment, we are concerned that the
popularity of the highest-yielding dividend strategies has caused
these stocks to become overpriced. For example, before the market
crash, Morningstar's Defensive supersector sold for 110% of the
price/earnings ratio of the S&P 500. Today, it sells for 114%,
indicating that it's gotten more expensive relative to stocks in
the S&P 500. Meanwhile, the expected long-term earnings growth
of this group has fallen sharply, from 96% of the expected earnings
growth of the S&P 500 to 88% today.
Our analysts currently see the fair value of the S&P 500 at
about 1,530, so it is currently trading at a price/fair value of
about 0.93. At the start of the year, we saw it trading at a P/FV
of about 0.85, so the market is not as attractive as it was in the
recent past. In addition, they see consumer staples stocks trading
expensively at a P/FV of 1.02 and utilities at 0.98, while more
economically sensitive sectors appear less expensive: energy is
trading at 0.90, industrials at 0.91, and technology at 0.89.
On the positive side for dividend-paying stocks, dividend payout
ratios are currently around 30%, much lower than the historical
average of about 58%. This suggests a margin of safety should we
enter a recession. In past recessions, firms have lifted the payout
ratio, which results in dividends being much less volatile than
earnings. And while the dividend yield on the S&P 500 of about
2.2% is below the 60 year average of about 3%, it is well above the
yield of the 10-year U.S. Treasury Note.
The Best of the Old Guard
Dividend-themed ETFs use different approaches to try to select the
best dividend stocks.
Vanguard Dividend Appreciation ETF (
) looks for stability and dividend growth by requiring a 10-year
track record of increasing dividends. It then market-cap-weights
the resulting stocks. The ETF has earned five stars, and while the
portfolio yield is not exciting, total returns have been. Vanguard
recently cut the fee on both of its dividend ETFs to just 0.13%.
This is an incredibly low expense ratio for what is essentially an
active stock selection process.
Vanguard High Dividend Yield (
) relies on diversification, essentially holding the
highest-yielding one third of the market, again at market-cap
weights. What we like here is that the approach produces a decent
dividend yield without taking on the stock-specific risk you can
have in funds with only 50 or so stocks.
WisdomTree Total Dividend (
) weights stocks by total dollar amount of dividends paid. What we
like about this approach is that it is very similar to a
market-cap-weighted approach and does not rely on arbitrary
screens. Like VYM, it also achieves excellent diversification,
which lowers the risk. Some other funds look for stable firms by
requiring a long track record of increasing dividends, but it could
take decades before these funds will even consider holding Apple (
), even though it will be one of the market's largest dividend
SPDR S&P Dividend (
) yield-weights liquid stocks from the S&P 1500 that have
increased dividends for 20 consecutive years. SDY recently loosened
this restriction from 25 years, which has increased the number of
holdings from 50 a few years ago to 80 today. We like this change.
As we have mentioned, holding too small a basket can result in
increased risks. Remember, the highest dividend-yielding stocks are
riskier, so diversification is critical.
First Trust Value Line Dividend Index (FVD) equal-weights stocks
with a market cap over $1 billion and a dividend yield greater than
the S&P 500 that rank in the top two quintiles in terms of
stability as measured by Value Line. Stability is based on price
volatility and measures of balance-sheet strength. While this fund
has been a top performer and earned 5 stars, at 0.70%, it is the
most expensive dividend fund mentioned in this article.
What We Don't Like
We like each of the above mentioned ETFs, but there are a few
dividend-themed ETFs that we don't much care for. Both of these
funds use a weighting mechanism other than market cap. If a fund is
to use a non-market-cap weighting scheme, we want to be sure that
the stock universe has been adequately screened or is sufficiently
PowerShares Hi-Yield Equity Dividend Achievers (PEY) requires 10
years of dividend increases, similar to VIG. But instead of
market-cap-weighting the resulting stocks, PEY weights the
highest-yielding 50 stocks by yield. This results in more of a
mid-cap portfolio with greater volatility. It also results in some
large sector concentrations, since financial and utilities tend to
have a large number of high-yield stocks. In 2007, prior to the
financial crisis, PEY had 61% of its portfolio in financials.
IShares Dow Jones Select Dividend Index (DVY) follows the Dow
Jones U.S. Select Dividend Index. That index applies several
screens to a broad universe of stocks and then weights the 100
highest-yielding survivors by dividend per share; this is similar
to price-weighting and can result in some odd positions. For
example, DVY holds 13% of the outstanding shares of small cap stock
Universal Corporation (UVV), making DVY by far the largest owner of
the stock. We don't want to see an index fund being the largest
owner of a stock.
The Jury Is Still Out on the New Guard
IShares High Dividend Equity (HDV) follows an index created by
Morningstar. HDV looks for stocks that have survived both a
qualitative and a quantitative screen. The qualitative screen is
based on an analyst-assigned moat rating, which is an indicator of
the sustainability of a firm's competitive economic advantage. The
quantitative screen is based on a firm's distance to default, which
combines both volatility and leverage to asses a firm's stability.
The highest-yielding 75 firms from the surviving group are weighted
by contribution to total dividends paid. This results in a fairly
concentrated fund, with a massive 60% of assets in just 10 stocks
and a whopping 9% in AT&T (T). We would prefer if more firms
were included to reduce this idiosyncratic risk. After all, what
makes 75 the magic number?
PowerShares S&P 500 Low Volatility (SPLV) selects the 100
least volatile stocks from the S&P 500, which is itself an
index of high-quality companies. SPLV then weights these 100 stocks
by the inverse of volatility. SPLV does not target dividends per
se, it just so happens that many dividend-paying stocks in the
S&P 500 have low volatility.
PowerShares S&P 500 High Dividend Portfolio (SPHD) contains
50 stocks from the S&P 500 that historically have produced high
dividend yields and low volatility. The index ranks all of the
stocks in the S&P 500 by dividend yield, then selects the 75
with the highest yield, but caps the number of stocks from any GICS
sector at 10. These 75 stocks are ranked by volatility, with the 50
least volatile stocks selected for the index. Stocks are weighted
by dividend yield.
Schwab U.S. Dividend Equity ETF (SCHD) follows the Dow Jones
U.S. Dividend 100 Index, a new index by Dow Jones. We mentioned
before that we don't really like the dividend index from Dow Jones
followed by DVY. However, this new index offers some improvements,
most notably the use of a modified market-cap-weighting approach
instead of a dividend-per-share weighting. It starts with the
highest-yielding half of all stocks that have maintained dividends
for 10 consecutive years. It then scores these stocks by cash
flow/debt, return on equity, dividend yield, and dividend growth
and selects the top 100 by the composite of these four metrics. At
only 0.07%, SCHD is currently the cheapest of the dividend-themed
funds. Schwab (SCHW) has made it clear that they are going to keep
their ETFs among the lowest-cost, and there is a lot to like about
ALPS Sector Dividend Dogs (SDOG) is a play on the "dogs of the
Dow" theory--the idea that the highest-yielding stocks in the Dow
Jones Industrial Average are likely oversold and will revert to the
mean over the next year. SDOG equal weights the five
highest-yielding stocks from the S&P 500 in each of the 10 GICS
sectors. This results in some large sector bets against financials
and in favor of utilities and telecom. The theory relies somewhat
on the fact that the 30 Dow stocks are all high-quality. Applying
this theory to the broader S&P 500 without some screen for
quality could be risky.
Morningstar licenses its indexes to certain ETF and ETN providers,
including BlackRock, Invesco, Merrill Lynch, Northern Trust, and
Scottrade for use in exchange-traded funds and notes. These ETFs
and ETNs are not sponsored, issued, or sold by Morningstar.
Morningstar does not make any representation regarding the
advisability of investing in ETFs or ETNs that are based on
Lessons From Retail's Casualties