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A Distinctive Dividend-Growth ETF

This quality strategy looks beyond past dividend growth.

Alex Bryan, 04/27/2016

WisdomTree U.S. Quality Dividend Growth ETF DGRW is a solid strategy that emphasizes profitable companies with the potential for strong dividend growth. It tracks an index that targets 300 dividend-paying stocks with high returns on assets and high returns on equity during the past three years and strong expected earnings growth. This creates a portfolio of highly profitable names with durable competitive advantages, such as Coca-Cola KOMicrosoft MSFT, and Apple AAPL. The fund's holdings consistently generate higher average returns on invested capital than the constituents of the S&P 500. While the fund has a short record, its tilt toward highly profitable, dividend-paying companies should give it an edge over its peers in the long term.

This strategy attempts to select stocks that can offer high dividend growth in the future, regardless of whether they have done so in the past. Many of these names would not pass a demanding screen for past dividend growth, similar to those that Vanguard Dividend Appreciation ETF VIG and SPDR S&P Dividend ETF SDY employ. There are pros and cons to each approach. A record of dividend growth is evidence that a firm's managers are committed to a shareholder-friendly payout policy and is a sign of strong and stable profitability. But restricting stock selection to this criterion excludes many emerging dividend-paying firms and ignores forward-looking information about the sustainability of dividend growth.

The fund's inclusion of earnings-growth forecasts in its selection criteria helps address this issue, but even if these forecasts are accurate, high earnings growth may not translate into dividend growth. Similarly, the inclusion of returns on equity and returns on assets in its criteria skews the portfolio toward healthy firms that may have the capacity to grow their dividends, but these metrics are not directly linked to payout policy.  

Despite its growth focus, the fund's dividend requirement and weighting approach keep it in the large-blend Morningstar Category. Its index weights each stock based on the value of dividends that it is expected to pay over the next year relative to the aggregate value for the portfolio. This approach causes the fund to overweight stocks that are cheap relative to their peers based on dividends. It also forces the fund to trim positions in stocks that have become more expensive relative to their peers and increase exposure to those that have become cheaper when it rebalances.

Fundamental View
This strategy emphasizes profitability and long-term growth over high dividend yields. Its dividend yield is usually only slightly higher than the S&P 500's. But there is a bigger difference in the average profitability of their constituents. Over the trailing 12 months through March 2016, the fund's holdings generated an average return on invested capital of 17.4%, while the corresponding figure for the S&P 500 was 12.7%. Consistent with its tilt toward more-profitable firms, the fund also has greater exposure to stocks that Morningstar equity analysts believe have wide Economic Moat Ratings, or durable competitive advantages.

The fund uses both return on assets and return on equity to gauge quality. While firms can boost return on equity through financial leverage (debt financing), return on assets strips out this effect and offers a cleaner measure of operating efficiency. These selection criteria influence the fund's sector weightings. For example, utilities generally do not have high returns on capital, as their returns are often regulated. Given the sector's muted profitability and low growth rates, the fund currently has no exposure to utilities stocks. The fund also has less exposure to real estate and financial-services stocks than the S&P 500 because they tend to have high leverage, which can hurt return on assets, and low expected growth. Similarly, weak profitability has kept the fund's energy stake small. It currently has greater exposure to consumer (cyclical and defensive) and industrial stocks than the S&P 500.

Because the fund's holdings tend to enjoy profitable growth, they should have the capacity to increase their dividends at a healthy clip over time. However, it is important to note that the expected earnings rate of the fund's holdings isn't significantly different than the S&P 500's, based on consensus estimates presented in Morningstar Direct. The link between expected earnings growth and actual dividend growth is not ironclad. Stocks can, and often do, miss earnings expectations. But earnings-growth forecasts are generally directionally correct. More importantly, dividend-payout rates (dividends/earnings) can change over time. A stock with strong earnings growth can elect to reinvest a larger share of its earnings in the future, which is often prudent when returns on capital are high. Because the fund does not screen for stocks with a record of dividend growth, as some of its peers do, it ignores potentially useful information about managers' willingness to raise their dividends.

Dividend-payout rates are a good indicator of dividend safety and growth potential. Lower payout rates usually indicate that a firm is reinvesting a larger portion of its earnings in the business to fuel growth. (This may not be the case if the firm has a large share-buyback program.) They also suggest that the firm has a larger cushion to protect its dividend payments if its earnings dry up. At the end of March 2016, the average payout rate of the fund's holdings was 0.51, a bit higher than the corresponding figure for the S&P 500 (0.41), based on forward-looking data.

Portfolio Construction
The fund employs full replication to track the WisdomTree U.S. Quality Dividend Growth Index. The selection universe includes all stocks from the WisdomTree Dividend Index, which covers all U.S. dividend-paying stocks that meet minimum liquidity requirements, with market capitalizations of at least $2 billion and dividend coverage ratios (earnings/dividends) of 1.0 or greater. WisdomTree assigns composite scores to these stocks based on growth and quality metrics and selects the top-scoring 300. The growth component represents 50% of the composite score. It is based on long-term earnings-growth forecasts (over the next three to five years). WisdomTree measures quality with return on equity and return on assets over the past three years. These two metrics each receive a 25% weighting in the composite score. When the index is rebalanced annually, each stock is weighted according to the value of dividends it is expected to pay out during the next year relative to the aggregate figure for the portfolio. On the rebalancing date, the index limits individual stock weightings to 5% and sector weightings to 20%.

Fees
The fund's 0.28% expense ratio is reasonable for this strategy, but there are cheaper alternatives. For example, Vanguard Dividend Appreciation offers similar exposure for a lower 0.10% fee. The managers engage in securities lending, the practice of lending out the fund's holdings in exchange for a fee. This ancillary income partially offsets the fund's expenses.

Alternatives 
Vanguard Dividend Appreciation VIG takes a very different approach but offers similar exposure to highly profitable stocks. It targets stocks that have raised their dividends in each of the past 10 years and weights its holdings by market capitalization. Firms that pull off that feat tend to have shareholder-friendly management teams, lucrative businesses, and strong competitive advantages.

Actively managed Vanguard Dividend Growth VDIGX (0.33% expense ratio) pays its managers to beat the index that VIG tracks. It carries a Morningstar Analyst Rating of Gold. Lead manager Donald Kilbride looks for stocks with a record of dividend growth and the capacity to sustain that growth in the future, and he can be flexible in his selection process. So far, Kilbride's approach has worked well. Vanguard Dividend Growth beat VIG from the latter's inception in April 2006 through March 2016 by 1.4 percentage points annualized.

FlexShares Quality Dividend ETF QDF (0.37% expense ratio) may be a more compelling option for income-oriented investors, as it offers a higher yield. It targets stocks with high dividend yields, high returns on equity, high dividend coverage ratios, and strong management efficiency (this includes metrics such as capital expenditures relative to sales). Unfortunately, the construction process here is not fully transparent. 

Schwab U.S. Dividend Equity ETF SCHD offers exposure to quality dividend payers for a much lower fee (0.07% expense ratio). It targets stocks with high return on equity, high cash flow/debt, high dividend yields, and strong dividend growth during the past five years. This tilts the portfolio toward value and wide-moat stocks.

 

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 clickhere 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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