The Old and New Guard of Durable Dividend Funds

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. In today's low-rate environment, dividend-paying stocks remain attractive options to many income-seekers. Morningstar's global director of ETF research, Ben Johnson, took a deep dive into the topic of dividend durability and ETFs investing in dividend-paying stocks in a recent issue of Morningstar ETFInvestor. He's here today to talk about that research.

Hi, Ben, thank you for being here.

Ben Johnson: Hi, Susan. Thanks for having me.

Dziubinski: Let's start out by talking about what makes a stock's dividend durable?

Johnson: Well, ultimately, durable dividends are rooted in durable franchises. When you look at stocks that pay regular dividends that have grown them over time, these tend to be more stable, more mature businesses, businesses that benefit from what we at Morningstar would call a wide or narrow "economic moat." So they're highly cash-generative. As they've grown into maturity, they have fewer reinvestment needs, so they're plowing less of that cash back into the business. And they're sharing more of that cash with time with their loyal shareholders and ultimately, ideally, growing those dividend payments over time. So many of these stocks are household names, names like McDonald's MCD or Coca-Cola KO or Procter & Gamble PG.

Dziubinski: Now in the article in ETFInvestor, you talk about the old guard of dividend-focused ETFs that include stocks based on their dividend track records. This would be ETFs like Vanguard Dividend Appreciation and Schwab US Dividend Equity. So let's talk specifically a little bit about these two ETFs. How are they similarly constructed, and what's different about them?

Johnson: Well, at face value, VIG, the Vanguard Dividend Appreciation ETF, and SCHD, the Schwab ETF, are more similar than they are different. So specifically, when it comes to selecting stocks that they'll include in their portfolios, they're looking for a track record of paying dividends, at least 10 years in the case of both of these funds. Once they've selected their stocks, both of these funds also weight those stocks on the basis of their market capitalization. So they're letting the market do a lot of the heavy lifting when it comes to position sizing: How much of that stock are they going to own in their portfolios? But really, the similarities stop there.

So even when it comes to looking at dividend track records, VIG looks specifically for at least 10 years' worth of dividend growth, whereas SCHD looks for stocks that have paid dividends, not necessarily grown them, for at least 10 years. What you see in the case of SCHD also is a narrower portfolio, so it limits the number of stocks it holds to 100. Whereas VIG historically has tended to hold around 250 stocks. SCHD also tends to tilt a little bit more toward value. It's got a bit of a value bias because one of the selection criteria that it employs, in addition to looking for stocks that have paid dividends for at least 10 years, is their current dividend yields. So that factors into how it selects the 100 stocks that are ultimately going to be represented in their portfolio. What that results in is, at the margin, SCHD has a little bit more of a value bias. It's got a narrower portfolio than VIG, and along with it comes a little incremental risk relative to what you see in VIG, which casts a wider net, tends to not lean toward value to the degree that SCHD does, and tends to have smaller positions in a larger number of names.

Dziubinski: You point out in the article, Ben, that these types of funds that are looking at dividend track records have a blind spot. Let's talk a little bit about what that blind spot is and what these types of funds are giving up as a result of that.

Johnson: Well, what these funds give up is the opportunity to participate in the dividend growth among an emerging class of dividend-growers. Those stocks that had never paid dividends previously had begun more recently--and might have up to nine years' worth of consecutive dividend growth. And what we've seen most recently is that this has characterized a significant chunk of some of the largest names in the technology sector, for example, and most prominently Apple AAPL, which is just within a hair's breadth now of being eligible for inclusion in both of these portfolios. So what investors are missing out on, given that there are these very stringent dividend-payment selection criteria in place, is the class of emerging dividend-payers, emerging dividend-growers.

Dziubinski: Ben, you say that there are some newer, a newer breed of dividend-focused ETF that sort of takes advantage of this blind spot of these other funds. Let's talk a little bit about some of these newer ETFs and what we think of them.

Johnson: Yeah, so there's a pair that I've looked at recently, the first of which is the ProShares S&P Technology Dividend Aristocrats ETF. The ticker for that one is TDV. And that portfolio really lands pretty squarely in the blind spot of VIG and of SCHD. So it's looking for dividend-payers, specifically within the tech sector. It's got a less stringent dividend-payment requirement and sweeps in some of those names that are otherwise absent from the dividend old guard, as we've described it. Now, the drawback to that is that, because of that less stringent dividend requirement, those dividends might not necessarily be as durable. The other issue is that it's a pretty narrow field. So by virtue of being a narrow field in a narrow portfolio, that leaves the underlying index having to equally weight the stocks in the portfolio. So it's actually been relatively underweight some of the largest, some of the strongest, dividend-payers and dividend-growers within that sector, most notably Apple, and as a result, it's actually underperformed the tech sector at large since its inception.

The second ETF that I've looked at that attempts to address this drawback, this blind spot of the dividend old guard is the VictoryShares Dividend Accelerator ETF. The ticker for that one is VSDA. And no different than TDV, what is in place in the case of this fund's index methodology is a less stringent dividend requirement. So, a dividend requirement that's half that required by VIG or SCHD. Specifically, this portfolio allows for the inclusion of stocks that have paid or grown dividends for just five years. That said, what we see is that the actual allocation to these names within the portfolio is quite small and quite small by design. While it attempts to address this blind spot, it really is just tipping its hat in the direction toward this category of emerging dividend-growers, as opposed to going all-in on them or owning them in a larger portion of the portfolio than might be desirable for an investor that's truly looking to address what, again, is in many cases a significant blind spot in the more stringent portfolios like those offered by VIG and SCHD.

Dziubinski: At the end of the day, Ben, is one option better for income-seekers than another? Should they stick with the old guard or go with the new guard?

Johnson: Ultimately, I think income-seekers should be focused on durability and dividend growth, especially in the context of the current low yield and increasing inflation environment. So the old guard has a lot to offer, despite some of its shortcomings. And many of those names that I've mentioned, many of the emerging dividend-growers that have come to the scene over the course of the past decade are just a few years away from being added to these portfolios. Many of them have dividends that have a lot of momentum and are likely to continue to grow for the decades to come. So many of these blind spots are probably no longer going to be blind spots if we're going to sit down and have this same conversation two or three years from now.

Dziubinski: Well, Ben, thank you so much for your time today and for walking us through some of the nuances of these dividend stock ETFs. We appreciate it.

Johnson: Thanks for having me.

Dziubinski: I'm Susan Dziubinski for Morningstar. Thanks for tuning in.

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