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By Paul Justice, CFA | 08-17-2011 03:02 PM

How Emerging-Markets Dividends Can Hedge Against Dilution

Excessive share issuance in developing markets has caused many stocks to lag GDP growth, which is why investors should consider a dividend strategy, says Morningstar's Sam Lee.

Paul Justice: Hi, there. I'm Paul Justice, director of exchange-traded fund research in North America for Morningstar. We've been focusing a lot of our resources on evaluating dividend-focused funds, particularly things that would either be dividend-weighted or just ways to generate some more income for folks in a low-yield environment. Today I'm going discuss a case here with Sam Lee, one of our ETF analysts, who's written a few pieces on this. In particular, we have a feature article now for the case for emerging-markets dividend funds.

Thanks for joining me, Sam.

Samuel Lee: Pleasure to be here, Paul.

Justice: So, the first thing I want to talk about is some of the academic work that we've seen around dividend investing itself. Could you shed a little light as to how much dividends have provided in return in the past and why a dividend strategy may be effective for folks?

Lee: So, it's kind of remarkable how much dividends have actually contributed to market returns worldwide. The majority of returns in almost every market come from dividends, and a very little comes from dividend growth or earnings growth. The fastest-growing economy in terms of per-share earnings growth was Sweden.

Justice: Over the last 100 years?

Lee: Yeah. The last 110 years from 1900 to 2010. That economy has only been around 1.77% annualized. So, people who are expecting fast-growing economies to actually translate into fast-growing earnings growth have been sorely mistaken.

Justice: So, if we look back, the Ibbotson Associates folks have compiled some of information on return streams say for U.S. stock investors over the last 100 years or so. What does that point to for dividends being a component of returns?

Lee: So, about 4 percentage points out of around 6% or 7% of real returns came from dividends, and then the rest came from dividend growth and multiple expansion.

Justice: So, really that return of cash back to shareholders has been the primary driver of returns over a long period of time, more than half.

Lee: Yes.

Justice: This is more so than any of the earnings growth that's embedded, which may lead to dividends down the road, but not always because there are certain factors that can drag down those returns. So, if we focus on dividend strategies in ETFs, we have some choices. Some will be focused on yield-paying stocks, and others will be focused on more growth-prone segments of the market. So, chances are, if I buy that dividend-weighted fund, I am not going to get a growth fund. It's typically going to be something like a value fund. Is that typically the case?

Lee: Yes. That's true. In all fairness, a dividend-weighted fund tends to load up on the same risk factors as a value fund. So, in a way, they're very, very similar, but despite the similarities, there are still some differences. Even after you control for the value affect, the dividend-weighted strategies have actually still done better over the long haul.

Justice: So, we would caution investors away from solely devoting a ton of assets to these dividend-weighted strategies because there are some downside risks that they need to be aware of. That's not actually something, I think, that should replace other classifications or strategies that you might employ. Could you talk about some of those downsides?

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