Near-term interest-rate risk doesn't change the core qualities that investors should look for in dividend-strategy exchange-traded funds.
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Despite the Federal Reserve's pullback on its tapering plans, investors remain spooked by the prospect of rising rates this Halloween season. Fixed-income investors aren't the only ones with cause to worry; dividend exchange-traded funds, a popular strategy during the recent years of record low rates, are also sensitive to rate increases. Dividend ETFs are not made equal, however. Their portfolios can vary widely from strategy to strategy depending on the methodologies of the indexes they track. Two of the largest dividend-strategy ETFs, Vanguard Dividend Appreciation ETF VIG and iShares Select Dividend DVY, have such different methodologies that only 17% of their portfolios overlap. So, because dividend strategies can differ so much, they'll be impacted differently by rate increases. Today, we pop the hood and see which of the largest and most popular dividend-strategy ETFs are most appropriately positioned to help investors gather dividend income without taking on significant interest-rate risk.
Now that the Fed has backtracked on its suggestions of tapering, is it realistic for investors to remain concerned about very near-term policy-rate increases? We think not, for a variety of reasons. First, the upcoming personnel changes at the Fed should calm some fears. Janet Yellen, a longtime proponent of monetary easing, is likely to be confirmed as the next Fed chair and is unlikely to set the Fed on a new course before next year at the earliest. Also, the economy's continued slow growth also indicates that rates are unlikely to dramatically tick up. At Morningstar's ETF Invest Conference in early October, Vanguard's chief economist Joe Davis said GDP growth is unlikely to rise out of the 2% range in the next 12 months.
In the less-immediate term, however, rates are likely to tick up. Vanguard expects tapering to begin before the end of the year and the Fed's policy rate to tick up in 2015. Morningstar bond strategist Dave Sekera also believes rates will meet the historical average over the long term. In aggregate, investors should be less concerned about rate increases in the near term and more focused on their long-term asset allocation as rates gradually rise over the next five to 10 years. If rates are likely to increase in coming years, what does that mean for the different dividend ETFs?
Rates tend to increase when the economy is experiencing accelerated growth. During such a situation, rising rates can be a headwind for dividend stocks because they compete with fixed income and growth stocks. Although dividend-paying companies provide stability and tend to have stable cash flow regardless of the interest-rate environment, they also have less growth potential than non-dividend-paying stocks from cyclical and speculative sectors. If the economy is booming, stable stocks don't generate as much investor demand as those from sectors like manufacturing or durable goods, which stand to benefit the most from economic growth. Dividend payers tend to outperform in stable or declining-rate environments, but struggle when rates are on an upswing. Sorting the market for dividend yield shows that the highest-yielding third of stocks had the worst historical performance in rising-rate environments.
Despite the potential for underperformance in a rising-rate environment, investors shouldn't throw out dividend stocks in preparation for a higher yield on the 10-year Treasury. Investors with rates on their minds should look for several qualities in a dividend-strategy ETF: sector allocation, dividend growth, and quality.
When rates rise because the economy is growing at a healthy clip, defensive-sector stocks in particular become an expensive trade. Morningstar fund analyst Alex Bryan discussed this topic in his article "The Hidden Risk of Investing in Stable Companies." Historically, defensive-sector stocks underperformed the broad U.S. equity market when rates were rising. The negative correlation between defensive-sector return and interest rates is notably damaging for utilities and telecoms. These firms are heavily regulated, which severely reduces their ability to grow at the same rate as other equities during an economic boom. Other rate-sensitive sectors include health care, financials, and tobacco. Josh Peters, the editor of the Morningstar DividendInvestor newsletter, made the case in a video last week for staying defensive in the long run. However, he reminded viewers that these stocks are likely to underperform the market in coming years as rates rise.
Investors who are primarily concerned with current income won't want to disregard defensive-sector stocks (their safety over entire market cycles is attractive, despite periodic underperformance), but those investing in dividend stocks for total-return purposes may want to avoid dividend-strategy ETFs that load heavily on defensive stocks. All dividend-strategy ETFs overweight defensive stocks compared with the S&P 500's approximate 25% allocation, but some are particularly tilted. ETFs with large allocations to defensive-sector stocks include First Trust Value Line Dividend Index FVD, iShares High Dividend ETF HDV (Disclosure: Morningstar Inc.'s Investment Management division collects asset-based fees for licensing this fund's benchmark index), iShares Select Dividend DVY, and PowerShares High-Yield Equity Dividend Achievers PEY. DVY is almost 30% allocated to utilities, making it one of the most rate-sensitive dividend ETFs available. Although investors should not automatically dismiss these ETFs, it's important to be aware of their consistent overweighting to the defensive sector and the impact that could have in a rising-rate environment.
The four most popular dividend ETFs (the aforementioned Vanguard Dividend Appreciation VIG and DVY, SPDR S&P Dividend SDY, and Vanguard High Dividend Yield Index VYM) have all demonstrated consistent sector allocation over the past five years. VIG's portfolio is evenly distributed between defensive-, cyclical-, and sensitive-sector stocks, and it most closely mirrors the distribution between sectors in the S&P 500. VYM underweights sensitive-sector stocks relative to other dividend ETFs. Investors should be wary of SDY's sector allocation: Weights have remained constant since 2011, but in previous years,the fund's financial services and utilities allocations fluctuated widely.
Regardless of rates, we prefer dividend ETFs that emphasize dividend growth instead of maximizing yield. Indexes that screen constituents for consecutive years of dividend growth and payment have the upper hand when it comes to keeping out overly risky companies that pay an unsustainable dividend. Dividend growth signals a management culture that values responsible capital allocation. In 2012, Ned Davis Research Group showed that companies with dividend growth outperformed the broad dividend-paying segment with less volatility. A company that grows its dividend from year to year can boost investors' total return with that growth alone. If a firm pays a 1.5% dividend with a 10% annual growth rate, within six years it will outpace a stock paying 3% without growth. Two of our favorites, VIG and SDY, require 10 and 20 years of dividend increases, respectively. Schwab U.S. Dividend Equity ETF SCHD is a new top choice, and it requires constituents to have paid dividends without fail for 10 years.
The counterargument is based on research that shows a high dividend payout ratio is correlated with accelerated earnings growth. However, funds that emphasize dividend income over dividend growth have not outperformed over the past five years. DVY has a weighted average dividend payout ratio of 61%, which is high compared with VIG's (39%), SDY's (51%), or SCHD's (48%) payout ratios. The fund's 12-month yield is the highest of the four at 3.30%, but over the past five years it has lagged its dividend-growth-oriented peers on a total return basis. The difference comes down to DVY's less stringent index construction. This ETF sorts for high-yielding stocks that pass mild dividend-sustainability screens, then weights them by the dollar amount of dividends paid--a weighting scheme similar to price weighting.
We also like a quality-tilted dividend strategy during any market cycle. You don't want to reach for yield and end up buying risky companies paying an unsustainable dividend. Over the past 85 years, the highest-yielding quintile of stocks did not produce the best return or the best risk-adjusted return. There are various ways to assess quality, but one of our favorite metrics is a stock's Morningstar Economic Moat Rating. Wide-moat companies have a trait that gives them a sustainable competitive advantage. Historically, wide- and narrow-moat companies cut their dividends less frequently than no-moat companies, and they also tend to exhibit less volatility. Among the largest dividend ETFs, VIG and VYM stand out for their allocations to wide-moat companies that exceed even that of the S&P 500. Both sport weightings to wide-moat stocks of more than 50%. Quality pays, as VIG's long-term projected earnings growth and historical earnings growth are the highest among the large dividend ETFs. SCHD is the most quality-oriented dividend ETF, with more than 60% of its stocks given a wide-moat rating, and it also has high projected earnings growth relative to the category. HDV, though potentially worrisome for its high defensive stock allocation, is also quality-focused and uses Morningstar analyst research as an index screen.
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 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 an