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By Ben Johnson, CFA and Christine Benz | 11-09-2015 06:00 AM

Why Have Quality-Dividend ETFs Underperformed?

A seven-year-long bull market has led to quality-dividend ETFs underperforming broader indexes, but Morningstar’s Ben Johnson thinks these funds’ time to shine will be during the next bear market.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors flocked to high-quality dividend-focused funds in the wake of the bear market. But they have been greeted with lackluster performance. Joining me to put that performance in context is Ben Johnson, he's director of global ETF research for Morningstar.

Ben, thank you so much for being here. 

Ben Johnson: I'm glad to be here, Christine.

Benz: Ben, let's talk about why we saw this stampede into high-quality dividend focused strategies, really in the wake of the bear market is when we saw the strategies start to generate a lot of interest.

Johnson: Well, I think it really fundamentally boils down to income, income, and income. So in the wake of the global financial crisis we have persisted through this ultra-low interest-rate environment whereby nominal yields are at all-time lows. Real yields (so, adjusting for inflation) are in some cases negative and have been so persistently for some time. We have entire segments of the investor base in the U.S. that need income now more than ever as they near or try to live through retirement. They are looking for reliable sources of income, be it from equities, be it increasingly from other esoteric asset classes that possess equitylike risk. Now one of the chief beneficiaries of this search for income, this search for yield has been dividend-paying equities, be it on a standalone basis, be it in the case of individual sectors such as the utility sector, and most notably in the case of dividend-oriented ETFs.

Benz: Okay. So among the dividend-focused ETFs, there are really two major flavors of them. Let's talk about what those are and the different attributes of those two subcategories.

Johnson: Sure, so if we look at the umbrella of dividend-oriented strategies, there are two semi-clean camps that we can separate that field into, going one step further down, and that in very loose terms is the growers and the yielders. So the growers are those strategies that look to build a portfolio of individual stocks that have grown their dividends with time. They show consistent, very reliable, and ideally growing dividend payouts. Now the yielders are a whole nother cohort. The yielders and the underlying benchmarks of the ETFs that look to isolate the yielders screen first and foremost on the basis of yield. So they're fairly agnostic to the sustainability of the dividend, they're just saying what is yielding the most right now. Something that might be yielding 7% to 8% and might have a volatile dividend, so it's a completely different camp. They're just looking for that headline yield they are not necessarily screening for sustainability and growth of that income stream.

Benz: So in the recent issue of ETFInvestor, you wrote about the high-quality cohort, that group of funds. And you pointed to performance, noted that it's sort of lackluster-looking relative to, say, a broad total stock market index fund. Why is that?

Johnson: I mean, we’re six-plus years now into the bull market. What you've seen is that during that span many of these high-quality dividend-oriented strategies have lagged relative to a broad market-capitalization-weighted exposure. So if you look at, for example, the  Vanguard Total Stock Market Index ETF VTI, it's actually outperformed fairly handily on a total-return basis some of these other quality-oriented dividend strategies. And a lot of that has to do with just the market context, that we've been in a bull market, and that these quality-oriented strategies tend to earn their keep, tend to really make hay when the markets are in sell-off mode, [when] they are in panic mode, [when] there is blood in the streets. These portfolios are very high-quality firms--firms that in the majority we at Morningstar think of as possessing either wider or narrow economic moats. So these sustainable competitive advantages that immunize to a certain extent those cash flow streams from what's going on in the broader market--they do best when the markets are at their worst and they tend to lag when markets are in bull-market mode. And we've been in bull-market mode now going on nearly seven years.

Benz: You noted though that they do tend to earn their keep on the downside. So these strategies generally held up pretty well during the financial crisis to the extent that funds were around then, because some of them are pretty new. How did they do during this recent sell-off that we had kind in the late summer, early fall of 2015?

Johnson: So in this most recent downdraft, we hit an air pocket here fairly recently with the markets. You saw a flash of exactly what you would expect. So their performance relative to S&P 500, relative to the total stock market was actually quite good. They tended to hold up much better vis-a-vis these other broader exposures.

Benz: Okay. So, let's take a closer look at a couple of the high-quality dividend-focused funds that you like. One is a Schwab fund. Let's talk about it.

Johnson: Yes, so the Schwab US Dividend Equity ETF, the ticker for that is SCHD, is one of our favorite amongst the growers. So, first and foremost, it's available at an extremely low cost. So the fee on this particular ETF is seven basis points. If you are a Schwab client you can trade it on a commission-free basis on the Schwab platform. So, first and foremost, the cost proposition is absolutely impeccable. In terms of the underlying portfolio, the index that this fund tracks looks to screen for companies that have paid dividends for 10 years straight, at a minimum, and ideally are growing those dividends with time. So what that yields in terms of the characteristic of the underlying portfolio is an uber-high-quality portfolio, and that is best evidenced by the "moatiness" of the portfolio. So if you look at the percentage of the portfolio's assets that are in either wide- or narrow-moat firms it's nearly 100%. So these are very high-quality firms, with sustainable competitive advantages that allow them to preserve and ideally grow over time, those cash flows that they are sharing with investors in the form of dividends.

Benz: And how about expenses, I know that’s an important thing to look at especially when you're focused on income.

Johnson: Right, absolutely. So again, the fee on this particular ETF at seven basis points is as low as they come in the dividend-oriented ETF space.

Benz: Okay. So that’s a grower. You also have a favorite among the yielders. Let's talk about the Vanguard fund that you like that does have a higher dividend yield.

Johnson: Yes, so the  Vanguard High Dividend Yield ETF, the ticker for that is VYM. We like it because it's almost a grower hiding amongst the yielders. And when I say that I mean that it explicitly looks to lean towards higher-quality firms, while simultaneously looking for higher yields amongst those firms. So amongst all of the dividend strategies that we would categorize as yielders, it's got the most moaty portfolio. And again, as it pertains to expenses, it's a fraction of the cost of its competitors in that yielder cohort. So, the annual fee on that one is 10 basis points [and] if you are a Vanguard client you can trade it on a commission-free basis through Vanguard. So, again, from a cost perspective, it's extremely attractive and, again, it's a quality angle on higher yields within the equity space.

Benz: Okay. Ben, I know dividends are always a hot topic among our Morningstar.com readers and viewers. Thank you so much for being here to share your insights.

Johnson: I am glad to be here. Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com. 

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