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How Emerging-Markets Dividends Can Hedge Against Dilution

Paul Justice, CFA

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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Lee: Well, first of all, dividend-weighted strategies are still equity strategies, so they're very risky. They are not suitable as lost bond income. I know that yields are very low right now, but if you're trying to replace 4% yield that you got from U.S. Treasuries 10 years ago with dividend stocks, just to get that income, you're actually shifting into a much riskier asset; it's completely inappropriate.

Justice: Yeah. It's a much bumpier to ride; there's a lot more volatility.

Lee: That's absolutely true. Also dividend-weighted strategies can underperform for a long periods of time, especially when there are growth manias. Think about the 1990s for the U.S. where for almost an entire decade, people who sat in boring dividend-paying stocks, lagged the market by tons and they were actually insulted and teased.

Justice: So, we've built up this case now and some of the downsides for dividend strategies, but we've mainly looked at either developed-markets aspects or the U.S. market in particular, when we get some of these results. A lot of your focus has been on emerging markets and dividends. Everybody thinks of emerging markets as kind of the hot-growth area, where you've seen great performance over the last decade. But we've actually seen some pretty good performance out of dividend players, and there are some fundamental reasons why we believe that dividend weightings there could be even better than it is in some of the developed markets. Could you talk about those?

Lee: Sure. First of all, people tend to mistake economic growth as being a really strong positive for stock market returns. Historically, that has not been the case, and the reason is, is what investors care about is per-share earnings growth over the long run. But when an economy is growing it begins sucking in capital from abroad and from domestic savers. So new capital is raised, and that dilutes away the share.

Justice: So, we've seen a lot more share issuance in a lot of the emerging markets, which takes away from your share of that company's earnings.

Lee: Yes, so it's kind of a race between how fast earnings can grow in general and how fast these fast-growing companies are actually issuing new shares and whether new companies are springing into existence. And because of that reason, earnings-per-share growth has actually lagged gross domestic product growth in most countries by quite a huge margin. So, you can realistically expect maybe 2% earnings growth over the long run after you account for all that share dilution.

Justice: What are some of the options investors have? We've identified, I believe, three different funds that focus on emerging-markets dividends.

Lee: So, one is WisdomTree Emerging Markets Equity Income DEM, and that is probably the biggest emerging-markets dividend ETF of them all. It has more than $1 billion in assets, and it carries a pretty good yield. The forward-looking yield is about 6%-7%. But the backward-looking yield, the distribution yield, has actually been much lower around 3.5% because of taxes and the fact that the portfolio constituents change.

Justice: So, you're not getting a great deal of tax efficiency there?

Lee: Certainly not.

Justice: That's especially with that dividend-weighting strategy which can often lead to falling-knife scenarios too, where you're going to load up on companies with high yields, just as the prices are plummeting?

Lee: So, one cause for concern with these dividend-weighted funds is that they actually tend to load up on financials. So, if you're actually kind of worried about highly leveraged companies and you're worried about the pace and the quality of credit creation in these emerging markets--because with all these banks shoveling out loans and consumers taking on these loans, think about the similarities to the subprime scandal in the U.S.--so, if you're kind of worried about that, there is some concern over there.

Justice: Now what about simply doing more a market cap-based strategy, but focusing on income still--State Street has a product out, that's the SPDR S&P Emerging Markets High Yield fund. I believe that's EDIV is the ticker, EDIV. Could you talk a little bit about that strategy?

Lee: So, EDIV, actually seeks higher-yielding companies. And it unlike DEM, it yield-weights, meaning that instead of weighting by the total quantity of cash that that company distributed over the past year, it actually weights by the yield. So, more distressed or higher-yielding stocks will take a much bigger share of the pie there. The way they mitigate the risks with that is they apply sustainability screens. So, trailing-three-year earnings growth has to be positive, and the company has to be profitable over one year.

Justice: Great. So, there are few additional screens in there but probably are still going to lead to some tax inefficiencies and certainly with both of these funds' much higher volatility than you would see in fixed-income and developed markets. So, we'd caution investors away from using these as income substitutes there?

Lee: Absolutely. For the more intrepid investor, they could go for emerging-markets, small-cap dividend companies; WisdomTree has one, DGS. That fund doesn't have as great of a yield, but it's more exposed to local growth trends. So, these companies tend to be more domestically oriented; they tend to be more related to consumer goods. These are things that emerging-markets consumers really want rather than these export-oriented companies that actually service rich-world countries.

Justice: Great. It probably mitigates some of the problems we've seen with GDP growth not being correlated with equity-return growth because you're actually focusing more on domestic consumers.

Lee: Yes.

Justice: Great. Well, thanks for your insights today, Sam. Thank you for joining us. For this and more insights into the ETF world, please check out our ETF Center on or our ETFInvestor newsletter.