Not All Dividend ETFs Are Created Equal

Asset managers have taken notice, and product proliferation is in full swing. Of the 158 dividend-screened/weighted ETPs that exist today, more than half are less than five years old (see Exhibit 2). As the menu of dividend-oriented 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. This month’s issue is dedicated to helping you to better discern the distinctions between these funds. Here I will focus on three specific characteristics of these funds: (1) dividend yield, (2) dividend growth, and (3) dividend sustainability.

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. This is 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, in Exhibit 3 I’ve plotted the current, average, maximum, minimum, and 75^th and 25th percentiles of the monthly 12-month yields for dividend exchange-traded funds that invest in U.S. large caps and that incepted before 2007. I’ve also included SPDR S&P 500 ETF (SPY, listed in the U.S.) as a point of reference. 

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

Dividend ETF (DHS, listed in the U.S.), had a 12-month yield of 10.32%, while the lowest-yielding fund was Vanguard Dividend Appreciation ETF (VIG, listed in the U.S.), with a 12-month yield of 3.09%. That’s a spread of 7.23 percentage points. The market downdraft provided a useful testimonial to the importance of understanding the particulars of the construction of these similarly labeled funds’ underlying benchmarks. Some ETPs clearly take on more risk than others when they go about building an income-oriented portfolio.

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, five of them track a benchmark that specifically screens its investable universe for firms with long track records of paying and/or regularly increasing dividends.

Dividend Sustainability
Perhaps even more important than dividend growth is the overall stability of a dividend-oriented ETP’s 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’ve calculated what I’ll refer to as their maximum dividend drawdown: the largest year-on-year decline in their annual dividend payment, which in every case took place in 2009. Unsurprisingly, four of the five ETFs whose benchmarks specifically screen their constituents on the basis of a steady history of paying and growing dividends had, on average, relatively muted dividend drawdowns relative to their peers.

Putting It All Together
In Exhibit 5 I’ve put it all together. The ETFs included are the same as those referenced above. Once again, I’ve included dividend-screened/weighted ETFs that invest in U.S. large caps and launched prior to 2007. I’ve also included SPY as a point of reference. In the table, I’ve listed these funds’ 12-month yields as of the end of May, 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 right-hand 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’ve ranked the ETFs in this group in descending order on the basis of their composite scores.

The ranking in Exhibit 5 gives a back-of-the-envelope assessment of the recent historical performance of the most-tenured members among the current crop of dividend-oriented ETPs. 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. What it does provide is a useful guide for conducting your own due diligence. Specifically, investors mulling an allocation to a dividend ETP 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 its 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 on the basis of historical and/or prospective growth should have better odds of growing their income streams over time. They tend to invest in firms that boast wider economic moats—sustainable competitive advantages that manifest in strong and stable profits.

4 | Stability Investors should place a premium on income stability, particularly in bear markets. On average, the ETPs in the sample I studied that are based on benchmarks that specifically screen their investable universe for growing and/or stable dividends fared better during the financial crisis, experiencing relatively muted dividend drawdowns versus their peers. 

*Disclosure: Morningstar, Inc.’s Investment Management division 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 visit http://corporate.morningstar.com/us/documents/Indexes/Investable-Products-Linked-to-Morningstar-Indexes.pdf 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.

Investments in exchange-traded funds involve risk and may not always be profitable. ETFs are traded on national exchanges and are thus subject to certain market risks. For example, the market price of an ETF may be at, above or below its net asset value as its NAV will fluctuate due to changes in the market value of its underlying holdings whereas its market price will fluctuate in accordance with changes in the NAV plus the ETF’s market supply and demand. Additionally, an ETF’s performance may not be exactly that of the index it is intending to track due to imperfect matches between the ETF’s underlying investments and those of the index because it incurs fees and expenses while the index does not. In transacting in ETFs, investors usually incur a brokerage fee/commission. Past performance is no guarantee of future results.