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Choosing the Right Dividend ETF

Alex Bryan, CFA
Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors love their dividends, but they should be sure to understand the pros and cons of various dividend strategies before buying a dividend-focused ETF. Joining me to discuss this topic is Alex Bryan. He is director of passive strategies research for Morningstar in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, let's start with a really basic question. Investors do like their dividends. But do dividend-payers outperform nondividend -payers over time?

Bryan: Historically, they have, yes. If you rank order stocks based on their dividend yield over the last 12 months, typically what you'll find is that there's a direct relationship between dividend yield and historic returns. The highest-yielding stocks have historically offered higher returns than their lower-yielding counterparts and those have in turn offered better returns than nondividend - payers historically.

Benz: You wrote a piece for Morningstar ETFInvestor in which you kind of unpacked that performance edge. And when you looked at different factors, you found that the outperformance of dividend-payers was actually correlated with the outperformance of certain factors that tend to be associated with dividend-paying stocks. Let's talk about that research.

Bryan: I think, it's easy for people to focus on the dividends and not look at some of the other characteristics associated with the types of stocks that pay dividends. What I found was there was not a causal relationship between dividends and performance, but rather dividends or high dividend yields tend to be associated with other characteristics that help predict stock performance. Typically, your higher-yielding stocks offer lower valuations, and regardless of the dividend payout policy, stocks that have traded at low valuations historically have outperformed stocks that have traded at higher valuations. That's the well-documented value effect.

Benz: Right.

Bryan: Also, stocks that do tend to pay dividends usually have more stable cash flows than stocks that do not. If you think about it, it kind of makes sense, right? Because the market tends to punish stocks that cut their dividends. So, managers are very reluctant to commit to dividends unless they have a high degree of confidence that they will be able to honor those payments throughout the business cycle.

Benz: Corporate managers.

Bryan: Corporate managers, right. Typically, the types of companies that do pay dividends do tend to have a bit more stable cash flows than your nondividend -payers. Those companies are more defensive, and historically, more defensive stocks have offered better risk-adjusted performance over the long term. So, it's a combination of lower valuations and then the more stable cash flows associated with those businesses that I think is the main driver of their attractive performance.

Benz: One thing investors sometimes do, and there are in fact ETFs set up to do this, is kind of gun for the highest possible income, dividend income. But there are real risks associated with looking for high dividend-paying stocks and maybe focusing disproportionately on that high-income stream. Let's talk about how those risks can crop up.

Bryan: While I mentioned that dividend-paying stocks in general do tend to have more stable cash flows than nondividend - payers , that's not necessarily the case with the highest-yielding stocks. If you focus very narrowly on yield, you do run the risk of owning a disproportionate share of companies that do have relatively poor business prospects, that are paying out a very high share of their earnings as dividends and they may not have as much of a cushion to buffer their dividends should their earnings fall.

There's a lot of examples throughout time of stocks that have offered very enticing yields, but have subsequently been forced to cut their dividends and then offered terrible returns at the same time. A good example that comes to mind, ConocoPhillips, back in February 2016 in the wake of a collapse in oil and gas prices had to cut its dividend payments and has since offered pretty lackluster returns. Bank of America is another example from the financial crisis that also offered a high dividend yield was forced to then cut it. I think it really is important to look beyond just yield.

Now, funds that diversify this risk across many holdings can help avoid these kinds of one-off, firm-specific risks. But the risk is still there. A good example of this is the Oppenheimer Ultra Dividend Revenue ETF. This is an ETF that offers one of the highest dividends yields of any fund out there. It basically targets the 60 highest-yielding stocks from the S&P 900 Index. And if you look at the back-tested performance of the index, because the fund hasn't been around that long, but if you look at how the indexes would have fared back in the financial crisis, it substantially underperformed the Russell 1000 Value Index because it tended to overweight some of these riskier names that faced relatively poor business prospects. I think it is important, like I mentioned, to look beyond just dividend yield.

Benz: I know you and the team look at the universe of dividend-paying funds in really two groups. One are the yielders, which we're talking about here, as well as the growers. Let's talk about that subsegment of higher-yielding ETFs. Is there one that you really like that you think does this strategy right?

Bryan: There's one of two ways you can go about dividend income in a way that will help mitigate some of these risks. One is through broad diversification because I think the more broadly diversified you are, the lower the risk is that you may have exposure to some of these distressed names. And the second strategy is to have a dual focus on quality and dividends.

But among the former dividend strategies that are well-diversified that help mitigate this risk, I really like the Vanguard High Dividend Yield ETF. The ticker is VYM. This strategy basically targets stocks that represent the higher-yielding half of all U.S. dividend-payers, and then it weights its holdings based on market capitalization. What that does is it tends to skew the portfolio toward the most mature names in the market. These tend to have durable competitive advantages, and it has a bit less exposure to the more distressed, highest-yielding names in the market. I mean, it is owning the higher-yielding half. But again, the really risky names are still a relatively small part of the portfolio. So, that's a strategy that is very well constructed. We give it a Morningstar Analyst Rating of Silver, and it charges a very low 8 basis points expense ratio. So, it's one of the lowest-cost dividend strategies on the market. So, that's one that we really like.

Benz: Let's take a look at the growers. These are dividend growth companies. Let's discuss kind of the thesis for that universe of companies. I know that investors have at various points in time gotten very enthusiastic about the dividend growers. But these aren't necessarily companies that have yields that are high in absolute terms or even a lot higher than the broad markets, right?

Bryan: That's right. Dividend growth is really more of a quality strategy than it is an income strategy. If you look at a lot of these dividend growth strategies, their yields aren't that much higher than the market; in some cases, they are not any higher than the market. These are strategies that tend to look for stocks that have a consistent history of growing their dividends. And if you think about the types of companies that can do that, these tend to be very profitable companies that are less sensitive to the business cycle than most. They tend to have durable competitive advantages that allow them to generate that consistency. There is a lot to be said for this strategy. It does tend to lead you to the more profitable names, and it's a bit more defensive than most yield-oriented dividend strategies.

Benz: And then among ETFs that use that dividend growth strategies , are there any that stand out as being particularly good in this space?

Bryan: Actually, Vanguard Dividend Appreciation is one of the better funds in this segment. It also charges a very low expense ratio. But this particular fund is looking for stocks that have a record of dividend growth over the past 10 years. It is looking for stocks that have raised their dividends in each of the past 10 years.

Now, that screen in and of itself doesn't necessarily capture everything you need to know. If you look at one of this fund's counterparts, it's a fund from PowerShares called the PowerShares Dividend Achievers ETF, that starts with that same dividend screen, looking for dividend-payers that have increased their dividends over the last 10 years. If you look at what that strategy had owned at the end of 2007, it actually owned Lehman Brothers, AIG, General Electric. All three of those companies weren't able to sustain that growth.

Benz: Needless to say, in the case of Lehman, right?

Bryan: That's right. But in the case of Vanguard, they recognize this and they apply some additional proprietary screens to try to weed out companies that are not likely to be able to sustain their dividend growth. Unfortunately, there's not a lot of transparency behind those. But if you look at the holdings, the differences between these two funds, which are similar, the screens tend to weed out the highest-yielding names from the portfolio, the most heavily indebted names, and some of the less profitable names.

Now, the end result of that is that Vanguard Fund has actually held up better during the financial crisis than the PowerShares fund. So, there is a real advantage to applying these additional screens. But it's still going to own some stocks that may not be able to sustain their growth but at least these steps help mitigate that risk to a certain extent. It's a fund that we rate Gold. We think very highly of it and I think it's probably one of the best in this space.

Benz: Just some expectation-setting. You said it's a quality strategy. There will be environments where it won't look particularly good relative to, say, the broad market?

Bryan: That's right. In fact, I would expect this type of strategy to do the best during market downturns but perhaps lag during a stronger market environment.

Benz: Alex, interesting topic. Thank you so much for being here to discuss it with us.

Bryan: Thank you for having me.

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