A Silver-Rated ETF Filled With Dividend Diehards

Targeting firms that have raised their annual dividends in each of the past 20 years has made SPDR S&P Dividend ETF SDY one of the highest-yielding, highest-quality funds in its Morningstar Category. Pursuing yield can be risky, but this fund's strict selection criteria underpin a risk-conscious approach. It retains its Morningstar Analyst Rating of Silver.

This fund replicates the S&P High Yield Dividend Aristocrats Index, which features the S&P 1500 constituents that have increased their annual dividend payments in each of the past consecutive 20 years. This is a demanding requirement that only consistently profitable firms can meet, giving this portfolio an appealing quality tilt. However, this screen is backward-looking and may admit firms that cannot sustain their dividend growth, as it ignores payout ratios and expected earnings growth. Additionally, this screen limits the depth of the portfolio and filters out some quality dividend payers, like Microsoft MSFT and Home Depot HD.

Stocks are weighted based on dividend yield, which increases the fund's yield. This can also increase exposure to some of the weaker names in the portfolio, like Exxon Mobil XOM, whose dividend yield climbed as its stock price fell. However, most stocks in the portfolio are highly profitable, owing to the initial dividend growth screen.

Dividend-yield-weighting pulls this portfolio into the large-value category. However, this fund's composition differs from most of its category peers. The average market capitalization of its holdings is much smaller than the Russell 1000 Value Index, and its long dividend growth requirement precipitates some notable sector tilts, including heavy exposure to utilities firms and a relatively small stake in technology. These sector biases can differentiate performance from the Russell 1000 Value Index but will not always pay off.

This fund carries an expense ratio of 0.35%. While there are cheaper index strategies available, this still ranks in the category's cheapest decile and gives this fund a leg up on its pricier peers.

Process This fund's disciplined approach produces a well-diversified portfolio of established stocks that should continue to deliver strong performance. Its 20-year dividend-growth screen would be more complete with forward-looking components, like dividend payout ratio, but this simple screen shapes a portfolio of high-quality stocks. It earns an Above Average Process rating.

The fund tracks the S&P High Yield Dividend Aristocrats Index. This index starts with the constituents of the S&P 1500 Index. These must clear additional liquidity screens and have a market cap of over $2 billion, which filters out many of the small-cap candidates. Then the index removes any firm that has not raised its annual dividend for 20 consecutive years, which narrows the pool considerably and distinguishes this index from its peers. The companies that check this final box form the index.

Index constituents are reviewed monthly to ensure that they are maintaining required dividend practices. If a company suspends or lowers its dividend, it is removed from the index. Stocks that make the cut are weighted by dividend yield. This approach increases the fund's yield, as well as its exposure to stocks with sinking prices, which may have deteriorating fundamentals. That said, the fund's initial dividend-growth screen keeps risk in check.

This weighting approach requires considerable trading around this index's quarterly rebalances and annual reconstitution. However, turnover here has consistently fallen below the category average.

Portfolio The "aristocrats" that constitute this portfolio are mature companies that generate stable cash flows. They tend to be late in their growth cycle, as they opt to distribute their earnings to investors instead of plowing them entirely back into their businesses. Companies like Coca-Cola KO, 3M MMM, and Caterpillar CAT are the types of industry stalwarts that investors can expect to find.

Just because firms have earned their place with consistent dividend growth does not mean that they will sustain that growth. This fund may pick up firms that grow their dividends faster than earnings, which is unsustainable. For example, Franklin Resources BEN has increased its dividend even as its earnings have declined over the past five years.

Yield-weighting gives this portfolio a value tilt. This fund leans heavily into value-oriented sectors, like financial services and industrials. Its stakes in the more growth-oriented technology and healthcare sectors are well below both the Russell 1000 Value Index and the broader market. These sector biases mark a source of uncompensated risk and may not always be rewarded by the market. This portfolio has a much smaller market-cap orientation than the Russell 1000 Value Index owing to its dividend-weighting approach and inclusion of mid- and small-cap stocks.

Although its dividend-growth screen narrows the selection universe, this is a well-diversified portfolio. The top 10 holdings represented just 18% of this portfolio at the end of September 2020, and it caps investment at 4% for each firm. Sector risk is effectively diversified as well; no sector represents more than one fifth of the portfolio.

Performance Over the trailing 10 years through September 2020, this fund outpaced the Russell 1000 Value Index by 50 basis points annualized. This stellar performance owed to its outperformance during market downturns and favorable exposure to industrials and basic-materials stocks.

The fund's quality tilt has helped it beat the Russell 1000 Value Index during market downturns, though it has tended to lag during rallies. For example, this fund drew on the steady performance of wide-moat staples like Clorox CLX and Walmart WMT during the coronavirus drawdown from Feb. 19, 2020, through March 23, 2020, to outperform the benchmark by 1.94 percentage points.

Attentive portfolio management has kept tracking error low. This fund trailed its benchmark by 35 basis points over the trailing three years through September 2020, which was right on par with its 0.35% expense ratio.

People State Street Global Advisors' global equity beta solutions team manages this fund. The team's global footprint, trading, and risk management processes enable low transaction costs and tight index tracking, supporting an Above Average People Pillar rating.

Michael Feehily, Karl Schneider, and Emiliano Rabinovich are the named managers on this fund. Feehily is the head of the global equity beta solutions team and serves as the chairperson for SSGA's trade management oversight committee. He has been with State Street since 1992 and joined SSGA in 2010.

Schneider is a managing director of SSGA and the deputy head of global equity beta solutions for the Americas region. He has been with SSGA since 1997. Rabinovich joined SSGA in 2006 and has managed this fund since 2017.

The managers' objectives are to mitigate tracking error, transaction costs, and the tax consequences of their trades. A team of analysts helps the managers effectively track the index by anticipating index changes and corporate actions. The management team's compensation is tied to index-tracking performance, operational efficiency, and contribution to process improvement, which aligns their interests with investors'. The team is subject to independent risk oversight.

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