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High Dividends With Less Risk

This ETF targets high-dividend payers that have offered a fairly smooth ride.

Alex Bryan, 10/07/2016

PowerShares S&P 500 High Dividend Low Volatility ETF SPHD targets high-dividend-yielding stocks in the S&P 500 but keeps risk in check by filtering out some of the riskier names from this group and capping exposure to individual stocks. This dual focus on yield and risk should help the fund continue to generate attractive performance relative to its peers over the long term. But large sector bets are still a source of risk.

The fund's benchmark screens for the 75 stocks with the highest-dividend yields in the S&P 500. It then removes the 25 stocks with the highest volatility over the prior year. This reduces its exposure to riskier stocks, which is important because narrowly focusing on dividend yield can court considerable risk. Many of the highest-yielding stocks have poor growth prospects and pay out a large share of their earnings as dividends, leaving a small buffer to cushion dividends if their earnings fall. Volatility isn't a perfect measure of risk, but less-volatile stocks tend to have more-stable cash flows than their more volatile counterparts and generally hold up better during market downturns.

Stocks that make the cut are weighted by dividend yield, though the fund caps these weightings at 3% to improve diversification. The resulting portfolio lands in large-value territory. It offers a considerably higher dividend yield than the Russell 1000 Value Index, but its holdings also tend to generate lower returns on invested capital.

Despite its volatility screen, the fund has exhibited only slightly lower volatility than the S&P 500. That's because its focus on dividend yield pulls it toward some of the riskier names in the index to begin with, which its volatility screen helps offset. That said, the fund has exhibited low sensitivity to market fluctuations (market beta of 0.69) from November 2012 through September 2016. This suggests that the fund has considerable exposure to risk that is not highly correlated with the broader market. During that time, the fund outpaced the Russell 1000 Value Index by 3.0 percentage points annualized. This was largely due to more-favorable exposure to consumer defensive stocks.

Fundamental View 
In a theoretical frictionless market, dividend payout policy shouldn't have any impact on stock returns (for further reading, see the Modigliani-Miller Theorem). A dividend payment should reduce the firm's stock price by an offsetting amount. But in practice, dividends often matter because they can impose greater discipline on managers in their capital-allocation decisions, leaving less money for lower-return investments. And managers may use these payments to signal their confidence in their firms' prospects. Dividends can also help address some behavioral issues, including many investors' reluctance to realize capital gains to meet income needs, and may give them the fortitude to weather market volatility. But they can be less tax-efficient than capital gains because investors do not have the option of deferring the associated tax liabilities. 

Like most strategies that focus on dividend yield, the fund has a pronounced value tilt. Mature, slow-growing firms tend to trade at lower valuations and pay out a larger share of their earnings as dividends than their faster-growing counterparts, which are investing more aggressively to expand. Both of these characteristics can lead to higher dividend yields.

Without any adjustments, the fund's aggressive pursuit of yield could give it an elevated risk profile, as some of the highest-yielding names have unattractive business prospects and may not be able to sustain their dividend payments. While the fund does not screen for dividend sustainability, its volatility filter helps reduce risk. Firms that have exhibited high volatility in the recent past tend to have more-volatile cash flows and more-uncertain prospects than their more stable counterparts. And they generally don't do as well during market downturns. Removing these firms should cut the fund's downside risk.

This compact portfolio looks and performs quite differently than its Morningstar Category peers. It only includes 50 holdings but limits exposure to firm-specific risk by capping individual positions at 3% of the portfolio. Yield weighting gives the fund a smaller market-capitalization orientation than the Russell 1000 Value Index. Sector weightings here also look quite different from the benchmark's. For example, because utilities stocks generally offer high yields and exhibit low volatility, they carry almost 3 times the weighting in this portfolio that they do in the index, which is a source of risk. The fund also has greater exposure to industrials and materials stocks than the benchmark and less exposure to the energy, financial-services, and healthcare sectors. This distinctive portfolio exhibited a low correlation of 0.72 to the Russell 1000 Value Index from November 2012 through September 2016.

The portfolio's turnover was close to 50% in fiscal 2013 through 2015. While relative yields and volatility tend to persist in the short term, they are not stable, which will create turnover. Yield weighting also contributes to the fund's turnover because yields tend to move inversely to market prices. Consequently, the fund must increase its exposure to stocks that have gone down in price and trim its exposure to names that have become more expensive relative to their dividends when it rebalances.

Portfolio Construction
The fund effectively offers diversified, risk-controlled exposure to high-dividend-paying stocks. It employs full replication to track the S&P 500 Low Volatility High Dividend Index. This index ranks all stocks in the S&P 500 by their 12-month trailing dividend yields (excluding special dividends) and screens for the 75 highest-yielding names. It won't admit any more than 10 stocks from the same sector. It then ranks these stocks on their realized price return volatility over the prior 12 months and targets the 50 least-volatile names. Stocks that make the cut are weighted by dividend yield. However, the index limits individual stock weightings to 3% of the portfolio and sector weightings to 25% to better diversify risk. S&P refreshes the portfolio twice a year in January and July. There are no constraints on turnover or buffer rules in place to mitigate unnecessary turnover, which is a small drawback. That said, the fund's holdings are very liquid and should be cheap to trade.

PowerShares charges a 0.30% annual fee for this offering, which is low relative to its actively managed counterparts in the large-value category and competitive with other dividend-oriented index funds. However, there are considerably cheaper options available, such as Vanguard High Dividend Yield ETF VYM, which charges a 0.09% expense ratio. Over the trailing three years through September 2016, the fund lagged its benchmark by 38 basis points annualized.

Vanguard High Dividend Yield is one of the lowest-cost dividend strategy funds available. It targets stocks representing the higher-yielding half of U.S. dividend-payers, excluding real estate investment trusts, and weights its holdings by market capitalization. This produces a well-diversified, low-turnover portfolio with a larger market-capitalization orientation than SPHD. The benchmark it tracks has been tough to beat over the long term.

Schwab U.S. Dividend Equity ETF SCHD (0.07% expense ratio) is also a lower-cost alternative. But unlike VYM, it takes quality considerations into account and doesn't focus solely on yield. SCHD targets 100 stocks with high dividend yields, return on equity, cash flow/debt, and five-year dividend-growth rates. This gives tilts the portfolio toward more-profitable names than SPHD, but its holdings tend to trade at higher valuations.

Vanguard Equity-Income VEIPX is a competitively priced actively managed alternative. Its Investor shares charge a 0.26% expense ratio. Michael Reckmeyer of Wellington Management runs about two thirds of the portfolio, while Vanguard's in-house quantitative equity group manages the remainder. Reckmeyer looks for stocks with high yields and undervalued growth prospects. The quantitative group select stocks from VYM's index with attractive valuations, momentum, earnings sustainability, and payout policy. This is a reasonable hands-on strategy that has a low fee hurdle to overcome. It carries a Morningstar Analyst Rating of Silver.


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.


Alex Bryan is an ETF analyst with Morningstar.

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