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Dual Focus: Profits and Dividends

This ETF balances its yield mandate with profitability to reduce risk.

Adam McCullough, CFA, 06/14/2017

This article is adapted from the ETF’s Morningstar Global Fund Report dated April 24, 2017.

FlexShares Quality Dividend QDF offers a diversified portfolio of highly profitable stocks with attractive dividend yields. This dual focus reduces the fund’s exposure to firms with weak fundamentals that may not be able to sustain their dividend payments, which is a risk that often accompanies a narrow focus on yield. The fund’s low fee should contribute to its edge over the long run, but its short live track record and nontransparent process limit its Morningstar Analyst Rating to Bronze.

The fund starts with the largest 1,250 U.S. stocks by market capitalization. Next, it ranks these stocks using a proprietary scoring model that combines profitability, cash flow, and management efficiency metrics. By targeting more-profitable dividend-paying stocks, this fund avoids some of the risks associated with chasing yield. It also restricts individual stock, industry, and sector weighting deviations from its parent index, which should reduce unintended bets. Despite its profitability criteria, the fund still leans toward the value end of the style spectrum and offers an attractive yield. From its inception in December 2012 through March 2017, this fund’s yield averaged 3.9%, nearly 50% more than the Russell 1000 Value Index.

Because this fund’s starting universe is larger than peer dividend-seeking funds’, its holdings skew to the smaller side. Its weighted average market capitalization is $40 billion, compared with over $55 billion for the Morningstar Category average. The fund’s profitability tilt is evident. Its return on equity has been nearly double the category average since inception, and net margins have been consistently higher.

This strategy launched in December 2012, so it has not established a meaningful record through a full market cycle. From inception through March, the fund returned 15.7%, outpacing the large-cap value category by 2.2% annually with similar risk. Its underweighting to energy and favorable stock selection in the consumer discretionary sector contributed the most to its outperformance.

Fundamental View
In a theoretical frictionless market, dividend-payout policy shouldn’t have any impact on stock returns: A dividend payment should reduce the stock price by an offsetting amount. In practice, dividends often matter. They can impose greater discipline on managers in their capital-allocation decisions, and managers may use these payments to signal confidence in their firms’ prospects. Dividends can also help address behavioral issues, giving investors fortitude to weather volatility and alleviating the need to realize capital gains to meet income requirements.

Chasing yield can be dangerous, though. The highest-yielding stocks could be under financial distress and more likely to cut their dividends than their lower-yielding counterparts. Many of these stocks pay out a large share of their earnings as dividends, leaving a small buffer to cushion these payments if their business deteriorates. This fund strives to sidestep this risk by balancing profitability and yield. If a stock is more profitable, it should be able to maintain its dividend during a downturn or raise its payout ratio in the future. Although this fund’s profitability tilt helps it avoid the riskier, highest-yielding stocks, its yield has consistently topped the category average by 30%.

This portfolio is different than traditional value benchmarks like the Russell 1000 Value Index. Most notably, it holds a higher percentage of consumer discretionary and technology names and has less exposure to energy and financial services. Not surprisingly, the fund’s holdings were expected to pay out a larger share (60%) of their earnings as dividends at the end of March than the Russell 1000 Value Index (41%), based on Morningstar calculations. They also tend to generate higher average returns on invested capital than those in the index. High profitability, coupled with conservative capital investment and low valuations, should allow the fund’s holdings to offer high free cash flow returns on capital.

The fund’s value and profitability tilts should continue to influence its performance. These characteristics have been associated with higher long-term returns, but they don’t always pay off. For example, in the United States, value stocks lagged their growth counterparts over the fund’s life, which detracted from its performance. But its profitability tilt gave it a small return boost.

The portfolio’s turnover averaged nearly 75% from inception through 2016 compared with 50% for the category. This higher turnover stems from a quarterly reconstitution and optimization approach that helps the fund react more quickly to stocks with deteriorating fundamentals. For example, this fund did not hold ConocoPhillips COP in early 2016 when it cut its dividend, while many of its peers that rely on backward-looking dividend sustainability metrics did. Despite its high turnover, it has not distributed any capital in its short life.

Portfolio Construction
The fund targets profitable, dividend-paying U.S. stocks and limits single-stock, industry, and sector weightings to reduce unintended bets. The result is a diversified portfolio that favors high-yielding stocks with strong fundamentals. It earns a Positive Process Pillar Rating.

The fund tracks the Northern Trust Quality Dividend Index, which targets dividend-paying stocks in the Northern Trust 1,250 Index, but applies a proprietary quality scoring model to avoid stocks that pay out a large share of their earnings as dividends. These stocks tend to be riskier than lower-yielding counterparts because they have less of a buffer to cushion dividend payments if their business deteriorates. To calculate a stock’s quality score, the index aggregates metrics such as profitability (return on equity), cash flow (dividend coverage ratio), and management efficiency (capital expenditures scaled by sales), comparing each stock against its sector peers. Dividend-paying stocks are grouped into quintiles within each sector, and the lowest scoring 20% are removed. Next, the fund uses an optimizer to construct a portfolio that maximizes its overall profitability score, while delivering a higher yield than the index and matching the index’s market beta. The optimizer also limits stock, industry, sector, and unintended style bets. Turnover is capped to 25% at each quarterly reconstitution.

This fund has a 0.37% expense ratio, less than the 0.8% large-value median, and it earns a Positive Price Pillar rating. But there are cheaper, more diversified dividend-oriented strategies. Over the trailing three years ended March, the fund lagged its benchmark by 46 basis points per year, more than its annual fee. This may owe to high transaction costs because of its frequent reconstitution.

Silver-rated Schwab U.S. Dividend Equity ETF SCHD (0.07% expense ratio) also balances yield with quality. SCHD targets 100 stocks with high dividend yields, return on equity, cash flow/debt, and five-year dividend-growth rates. Its process is more transparent than QDF’s, and it has a higher average market capitalization. Its sector weightings are capped at 25%, but it looks very different from the category at times.

Vanguard High Dividend Yield ETF VYM (0.08% expense ratio) is a more diversified portfolio, though it tends to have a lower dividend yield and has a much higher average market cap compared with QDF. It sorts U.S. dividend-paying stocks by yield, and targets the higher-yielding half, weighting them by market capitalization. VYM’s low fee and broad market-cap-weighted approach support its Analyst Rating of Silver.

Bronze-rated PowerShares S&P 500 High Dividend Low Volatility SPHD (0.30% fee) selects 50 high-yielding stocks from the S&P 500, but it seeks to reduce risk by targeting stocks with low volatility, rather than high profitability. SPHD launched around the same time as QDF and has offered a similar yield, though it tends to have a larger market-cap orientation.

WisdomTree LargeCap Dividend ETF DLN (0.28% fee) selects the largest 300 stocks by market capitalization from a proprietary index that weights holdings by the value of dividends each stock is expected to pay over the next year relative to the aggregate value of the portfolio. DLN’s broad diversification and weighting by dividend payment reduce its risk and support its Bronze rating.

This article originally appeared in the June/July 2017 issue of Morningstar magazine.

Adam McCullough, CFA, is an analyst on Morningstar’s manager research team, covering passive strategies.

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