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Dividend ETFs 2.0

The new breed of dividend-themed ETFs offer some improvements, but our old favorites are still worthy of consideration.

Michael Rawson, CFA, 10/31/2012

Dividend-focused exchange-traded funds that offer a decent yield and instant diversification have been wildly popular in recent years, thanks to the paltry yields in fixed income. To satisfy investor demand, ETF providers have launched a slew of new products. Many of these ETFs offer more intelligent designs than the first generation of dividend-focused ETFs. The improvement in structure is in response to some flaws in some of these older ETFs. Here we will discuss some of these flaws and highlight the new ETFs that we like.

According to data from Ken French's website, dividend payers have outperformed nonpayers over the past 85 years. If we sort the dividend payers into five quintiles, we find that the highest-yielding bucket, quintile 5, does not have the highest return or highest risk-adjusted return--that distinction belongs to quintile 4. In other words, reaching too far for yield can lead to suboptimal results. This suggests that, with appropriate screening, we can build a better dividend fund than one that naively buys just the highest-yielding stocks.

In the current economic environment, we are concerned that the popularity of the highest-yielding dividend strategies has caused these stocks to become overpriced.  For example, before the market crash, Morningstar's Defensive supersector sold for 110% of the price/earnings ratio of the S&P 500. Today, it sells for 114%, indicating that it's gotten more expensive relative to stocks in the S&P 500. Meanwhile, the expected long-term earnings growth of this group has fallen sharply, from 96% of the expected earnings growth of the S&P 500 to 88% today. 

Our analysts currently see the fair value of the S&P 500 at about 1,530, so it is currently trading at a price/fair value of about 0.93. At the start of the year, we saw it trading at a P/FV of about 0.85, so the market is not as attractive as it was in the recent past. In addition, they see consumer staples stocks trading expensively at a P/FV of 1.02 and utilities at 0.98, while more economically sensitive sectors appear less expensive: energy is trading at 0.90, industrials at 0.91, and technology at 0.89.

On the positive side for dividend-paying stocks, dividend payout ratios are currently around 30%, much lower than the historical average of about 58%. This suggests a margin of safety should we enter a recession. In past recessions, firms have lifted the payout ratio, which results in dividends being much less volatile than earnings. And while the dividend yield on the S&P 500 of about 2.2% is below the 60 year average of about 3%, it is well above the yield of the 10-year U.S. Treasury Note.

The Best of the Old Guard
Dividend-themed ETFs use different approaches to try to select the best dividend stocks.

Vanguard Dividend Appreciation ETF VIG looks for stability and dividend growth by requiring a 10-year track record of increasing dividends. It then market-cap-weights the resulting stocks. The ETF has earned five stars, and while the portfolio yield is not exciting, total returns have been. Vanguard recently cut the fee on both of its dividend ETFs to just 0.13%. This is an incredibly low expense ratio for what is essentially an active stock selection process.

Michael Rawson, CFA is an ETF Analyst with Morningstar.

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