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We live in interesting times. Current market conditions are
unusual and require exceptional investment skill. An unholy
combination of quantitative easing and a flight away from risky
assets has helped to create an exceptionally low-yield environment.
Investors are seeking decent returns with a febrile intensity.
One of the quirks of the current environment is that corporate
balance sheets and cash flows are in much better financial shape
than those of governments. But investor uncertainty is dampening
equity market valuations. The net result is that the dividend yield
for many companies is easily outstripping returns on both
government debt and many investment grade corporate bonds.
Investors are taking a page out of the 1950s play book and are
no longer primarily seeking capital growth from equities but
instead focusing on dividend income. The result? An explosion of
interest in dividend income funds.
Aymeric Poizot, a managing director in the fund and asset
manager group at Fitch Ratings, says:"Over the long run, the
biggest contribution to total shareholder returns comes from
dividend income. In a low growth environment, dividend income
becomes even more important as capital returns dwindle."
This investment strategy has traditionally been one that only an
active manager could provide, cherry picking the best yielding
stocks for a fund. But investors are now confronted with an
increasing variety of formula-driven, passive dividend funds, in
the form of equity dividend ETFs.
Dodd Kittsley, global head of ETP research for BlackRock,
says:"There has been a significant interest in equity dividend
income products. By the end of June, assets under management in
these funds had reached just over US$62 billion, with US$10 billion
of new cash flows into this product group in the year to date."
There is, however, a significant regional split, according to
Kittsley. Investor interest in dividend-focused ETFs is heavily
concentrated in US-listed products. These command over 80 percent
of worldwide assets under management (AUM) and have attracted more
than 90 percent of this year's cash flows into such funds.
"While the trend is not quite as pronounced in Europe, we've
seen new cash flows of over US$500 million so far in 2012, which is
almost the same as the inflows for the whole of last year," he
adds. "European dividend-focused ETFs have AUM of US$4.4
Investors are choosing ETFs rather than the more traditional
actively managed route into high-yielding equity because the
providers of exchange-traded funds are offering more sophisticated
ways of choosing dividend-paying stocks than simply selecting the
highest-yielding equities from a universe of stocks. "Using
rule-based methodologies we can create very different economic
exposures. These are very similar to the tools that an active
manager uses:we can screen for quality, dividend sustainability and
payout ratios," says Kittsley.
These rules can be finely tuned to factors such as payout ratios
of more than 60 percent or years of successive dividend increases.
"Many of the funds are weighted by the dividend yield of the
underlying securities," adds Kittsley.
Investors are now able in a single trade to buy a diversified
basket of securities that are desirable. "We've seen a lot of
interest in securities with high-quality stocks with sustainable
dividend income," he says.
If the circumstances at a company change suddenly-for example,
it cuts its dividend-it can be dropped immediately from the index
underlying the ETF. If there's an early warning sign, such as the
payout ratio exceeding 60 percent, then the stock will be booted
out at the next index rebalancing date.
While these factors undoubtedly help to keep the right
constituents in the investment vehicle, these actions still might
not be timely enough. An active manager keeping a close watch on
his portfolio could spot trouble brewing before it was reflected in
a dividend cut, for example.
"That's why some of the indices that the equity income ETFs are
based upon do have additional screening criteria relating to
quality," adds Kittsley.
But even with the best possible design, these passive vehicles
will be largely based on historical data. And any such approach is
flawed by design, says Fitch's Poizot:"It's very risky to be
completely backward-looking today because the environment is so
uncertain that the past is likely to be an exceptionally bad
indicator of the future."
"It's very difficult for a passive vehicle that uses an
algorithm to capture the strategic elements of companies such as
competitive advantage and pricing power. That's only really
possible to do on an active basis," Poizot adds.
Some have concerns that these equity index ETFs end up with too
high a proportion of their funds invested in a narrow range of
"The quality screening criteria does help to reduce this problem
so that certain problem sectors like financials can be avoided,"
For example, iShares' US High Dividend Equity Fund
(NYSEArca:HDV) has a financials weighting of less than 2 percent.
It does, however, have a weighting of 28 percent to healthcare, 21
percent to consumer goods, 18 percent to telecoms and 17 percent in
Poizot explains:"Almost 40 percent of the typical equity
dividend income fund is invested in regulated sectors. Given the
economic problems facing many European governments, investors need
to keep in mind that these dividends may not be sustainable."
Fitch's peer group of actively managed dividend funds are
currently overweight an average 13 percentage points in financials,
telecoms and utilities against the average of the Lipper Global
Equity Europe peer group. Certain funds are overweight up to 30
percentage points in these sectors.
There is evidence that these sector biases have an impact on
dividend-focused funds. According to Fitch, dividend income funds
underperformed broader European equity funds by 2.0 percent over
five years and were also more volatile-annualised volatility was
20.8 percent for dividend funds versus 18.1 percent for the broader
sample over the same period. This underperformance can be
attributed in large part to the poor performance of financials
during the crisis.
Over three years, performances were more in line but the return
on dividend income funds were still more volatile than broader
European equity funds.
Poizot says:"Growth stocks have outperformed value stocks since
2007. Many stocks that provide high dividend income are not growth
stories. In the current low growth environment, coupled with
deleveraging, the market has favoured quality growth
Investors should consider carefully the risks associated with
both active and passive dividend income strategies. Finding a
reliable and higher source of income in the current economic
environment may not be as easy as relying simply on the highest
dividend payers from the past.
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