Christine Benz: Hi. I'm Christine Benz from Morningstar.com. Investors have been sending torrents of assets to exchange-traded funds that focus on dividend-paying stocks, but Morningstar associate director of fund analysis, Shannon Zimmerman thinks they shouldn't disregard actively managed dividend-focused products. Shannon, thank you so much for being here.
Shannon Zimmerman: Good to be with you, Christine.
Benz: So Shannon, why should investors consider actively managed funds, given that they typically will have significantly higher or at least somewhat higher expense ratios than ETFs do?
Zimmerman: Sure. Well big picture-wise, one reason that you might want to consider owning both--it's not an either/or proposition. You can own both indexed products and actively managed products. If you think about it just in terms of strategies, broadly speaking, those are two strategies; index, or passive investing, and actively managed investing are two different approaches to investing in the market. As with any strategy, the success will wax and wane over time. There'll be periods when indexing holds sway and there'll be periods when active management holds sway. I tend to think that, particularly when you get into asset classes where there have been bubbles or bubbles seem to be inflating--I think that's true right now of dividend-paying stocks, because people are scrambling after yield and they're pushing up the valuations of lot of companies that pay dividends--that's a good time to consider using an active manager who can be opportunistic in what seems to be an increasingly richly priced area of the market. If you go to that route, certainly there are a number of very talented long-term successful managers who work that space pretty effectively.
Benz: Shannon, there are really two key strains of dividend-focused mutual funds. One is sort of that tried-and-true strategy, usually a large-cap value manager using some sort of an equity-income strategy. Let's talk about what you think is a good example of that fund type, one that investors should consider.
Zimmerman: T. Rowe Price Equity Income is a good example of that type of fund. However, there are some limits to how closely that approach applies. Brian Rogers is a longtime manager and has a terrific track record versus his benchmark, certainly versus his category peers. He does have an equity-income mandate. But the fund, if you look at it right now, only yields around 2%, that's slightly higher, but only very slightly higher than the broad market. Wait a minute, this is an equity-income fund; shouldn't it have 3%, 4%, or 5%? Not the way that he does it. I mean, right now, that kind of yield is very difficult to come by, and Rogers is not a big risk-taker. He doesn't scramble after yield in a way that might allow him to get that level of payout at a level of risk that would be unacceptable to him in the context of this portfolio.
So, basically even though there is an equity-income mandate and though it does yield, again, slightly higher than the broader market and in the past has had a bigger margin of payout versus the broader market, Rogers is really a traditional stock-picker. It's a large-value fund, and he's looking for bargains typically among financially healthy companies. In a way, the equity-income mandate sort of puts him in a position of looking for dividends, not just for the sake of the payout that they can contribute to the portfolio, but as a proxy for financial health. Are these companies going to have wide economic moats and dominate the areas of the market that they play in? Are they going to be able to sustain their dividends over time? Those are the questions that he asks, when putting together the portfolio, but as all investors should, he also keeps his eye on total return.
So, if you are just focused exclusively on yields, a lot of people do seem to be these days, well, then you're taking your eye off the potential for price appreciation or price erosion. And as I'm fond of saying, if price erosion takes back what the yield is giving, then you're really not earning anything at all. So, at the end of the day you need both: You need a sustainable yield producing income to contribute to the total return, and then the potential for price appreciation among higher-quality companies. And there's been a bit of a bubble among those, too, so the valuations are looking a bit stretched.
Benz: So, you think Rogers illustrates what active managers can do for you in this space in terms of keeping you out of yield traps, companies with very high yields, but maybe price erosion that is down the road?
Zimmerman: Maybe they have high yields because price erosion has already occurred for good reason. They are not financially healthy in a way that will allow them to get into a portfolio like the one Rogers runs.
Benz: Another flavor of dividend-focused funds is a dividend-growth strategy, and we've really seen a lot of popularity among these funds recently. Let's talk about another fund that you think fits that bill and is a good worthwhile example of that type of investment.
Zimmerman: Right. It's Vanguard Dividend Growth, which is one of the cheapest, if not the cheapest, funds that has dividend in the name of the fund. But as you say it is the second strain, it's not as traditional dividend-focused fund in the sense that manager Don Kilbride wants to maximize what the yield of the portfolio is. What he is doing is somewhat akin to what Brian Rogers is doing, using dividend as a proxy for financial health. It's a very healthy portfolio of about 50 holdings typically, and again this portfolio now is yielding just 2%, only slightly higher than the market. But the fund is not just Vanguard Dividend; it's Vanguard Dividend Growth.
So, as he does his analysis and puts together the portfolio, he is looking again at that dividend as a proxy for financial health. Then as he digs into the financials, [he looks at whether] this is a company that's going to be able to not only sustain to the current dividend, but grow it over time because stock prices and dividend growth can sort of move in tandem and that's a key part of the strategy in play in this fund.
Benz: One assertion that you've made, Shannon, is that if people are looking at actively managed products they really need to keep an eye on what they are paying because that expense ratio gets deducted directly from your yield. How do you know what is too much to pay?
Zimmerman: At Morningstar.com, we have several ways of looking at fees. You can look at the fund versus its category average, which I think is always a valid thing to do, but it's worth remembering that when you're doing that, you're not really comparing like with like. So you have retail share classes versus institutional share classes, and typically there is a huge differential between expense ratios of those kinds of share classes.
In addition to the category average, which is available on Morningstar.com, we have the fee-level scores, as well. We're taking into account not just the area of the market that a fund targets, but also the distribution channels. So is it a retail share class? Is it an institutional share class? You get to be in a position of comparing like with like, and that's helpful. Those are two tools in the toolbox.
I'd mention a third fund Oakmark Equity & Income, which has a terrific long-term track record and terrific manager. If you look at the price tag, it's below the category average; it's below-average relative to its fee level of its peer group that takes into account the distribution channel, but it's not below-average relative to funds that have a similar-sized asset base, right. So there is a way that you need to sort of keep in mind. In any fund--small-cap, large-cap, whatever the mandate is that its manager is working with--as a fund grows its assets base, it should be able to pass along economies of the scale to its shareholders in the form of lower and lower expense ratios. Oakmark Equity & Income is certainly reasonably priced in absolute terms, but relative to the assets that it has under management and relative to the asset growth--although in the last couple of years it has seen some outflows--but still it's one of the largest equity-income funds in our database certainly. It should be cheaper still.
Benz: Well, Shannon, thank you so much for sharing your insights into this category. We appreciate you being here.
Zimmerman: Good to be with you.
Benz: Thanks for watching. I am Christine Benz for Morningstar.com.