Dividend ETFs 2.0

Dividend-focused exchange-traded funds that offer a decent yield and instant diversification have been wildly popular in recent years, thanks to the paltry yields in fixed income. To satisfy investor demand, ETF providers have launched a slew of new products. Many of these ETFs offer more intelligent designs than the first generation of dividend-focused ETFs. The improvement in structure is in response to some flaws in some of these older ETFs. Here we will discuss some of these flaws and highlight the new ETFs that we like.

According to data from Ken French's website, dividend payers have outperformed nonpayers over the past 85 years. If we sort the dividend payers into five quintiles, we find that the highest-yielding bucket, quintile 5, does not have the highest return or highest risk-adjusted return--that distinction belongs to quintile 4. In other words, reaching too far for yield can lead to suboptimal results. This suggests that, with appropriate screening, we can build a better dividend fund than one that naively buys just the highest-yielding stocks.

In the current economic environment, we are concerned that the popularity of the highest-yielding dividend strategies has caused these stocks to become overpriced.  For example, before the market crash, Morningstar's Defensive supersector sold for 110% of the price/earnings ratio of the S&P 500. Today, it sells for 114%, indicating that it's gotten more expensive relative to stocks in the S&P 500. Meanwhile, the expected long-term earnings growth of this group has fallen sharply, from 96% of the expected earnings growth of the S&P 500 to 88% today. 

Our analysts currently see the fair value of the S&P 500 at about 1,530, so it is currently trading at a price/fair value of about 0.93. At the start of the year, we saw it trading at a P/FV of about 0.85, so the market is not as attractive as it was in the recent past. In addition, they see consumer staples stocks trading expensively at a P/FV of 1.02 and utilities at 0.98, while more economically sensitive sectors appear less expensive: energy is trading at 0.90, industrials at 0.91, and technology at 0.89.

On the positive side for dividend-paying stocks, dividend payout ratios are currently around 30%, much lower than the historical average of about 58%. This suggests a margin of safety should we enter a recession. In past recessions, firms have lifted the payout ratio, which results in dividends being much less volatile than earnings. And while the dividend yield on the S&P 500 of about 2.2% is below the 60 year average of about 3%, it is well above the yield of the 10-year U.S. Treasury Note.

The Best of the Old Guard
Dividend-themed ETFs use different approaches to try to select the best dividend stocks.

 Vanguard Dividend Appreciation ETF (VIG) looks for stability and dividend growth by requiring a 10-year track record of increasing dividends. It then market-cap-weights the resulting stocks. The ETF has earned five stars, and while the portfolio yield is not exciting, total returns have been. Vanguard recently cut the fee on both of its dividend ETFs to just 0.13%. This is an incredibly low expense ratio for what is essentially an active stock selection process.

 Vanguard High Dividend Yield (VYM) relies on diversification, essentially holding the highest-yielding one third of the market, again at market-cap weights. What we like here is that the approach produces a decent dividend yield without taking on the stock-specific risk you can have in funds with only 50 or so stocks.

 WisdomTree Total Dividend (DTD) weights stocks by total dollar amount of dividends paid. What we like about this approach is that it is very similar to a market-cap-weighted approach and does not rely on arbitrary screens. Like VYM, it also achieves excellent diversification, which lowers the risk. Some other funds look for stable firms by requiring a long track record of increasing dividends, but it could take decades before these funds will even consider holding  Apple (AAPL), even though it will be one of the market's largest dividend payers.

SPDR S&P Dividend (SDY) yield-weights liquid stocks from the S&P 1500 that have increased dividends for 20 consecutive years. SDY recently loosened this restriction from 25 years, which has increased the number of holdings from 50 a few years ago to 80 today. We like this change. As we have mentioned, holding too small a basket can result in increased risks. Remember, the highest dividend-yielding stocks are riskier, so diversification is critical.

 First Trust Value Line Dividend Index (FVD) equal-weights stocks with a market cap over $1 billion and a dividend yield greater than the S&P 500 that rank in the top two quintiles in terms of stability as measured by Value Line. Stability is based on price volatility and measures of balance-sheet strength. While this fund has been a top performer and earned 5 stars, at 0.70%, it is the most expensive dividend fund mentioned in this article. 

What We Don't Like
We like each of the above mentioned ETFs, but there are a few dividend-themed ETFs that we don't much care for. Both of these funds use a weighting mechanism other than market cap. If a fund is to use a non-market-cap weighting scheme, we want to be sure that the stock universe has been adequately screened or is sufficiently diverse.

 PowerShares Hi-Yield Equity Dividend Achievers (PEY) requires 10 years of dividend increases, similar to VIG. But instead of market-cap-weighting the resulting stocks, PEY weights the highest-yielding 50 stocks by yield. This results in more of a mid-cap portfolio with greater volatility. It also results in some large sector concentrations, since financial and utilities tend to have a large number of high-yield stocks. In 2007, prior to the financial crisis, PEY had 61% of its portfolio in financials.

IShares Dow Jones Select Dividend Index (DVY) follows the Dow Jones U.S. Select Dividend Index. That index applies several screens to a broad universe of stocks and then weights the 100 highest-yielding survivors by dividend per share; this is similar to price-weighting and can result in some odd positions. For example, DVY holds 13% of the outstanding shares of small cap stock  Universal Corporation (UVV), making DVY by far the largest owner of the stock. We don't want to see an index fund being the largest owner of a stock.

The Jury Is Still Out on the New Guard
IShares High Dividend Equity (HDV) follows an index created by Morningstar. HDV looks for stocks that have survived both a qualitative and a quantitative screen. The qualitative screen is based on an analyst-assigned moat rating, which is an indicator of the sustainability of a firm's competitive economic advantage. The quantitative screen is based on a firm's distance to default, which combines both volatility and leverage to asses a firm's stability. The highest-yielding 75 firms from the surviving group are weighted by contribution to total dividends paid. This results in a fairly concentrated fund, with a massive 60% of assets in just 10 stocks and a whopping 9% in  AT&T (T). We would prefer if more firms were included to reduce this idiosyncratic risk. After all, what makes 75 the magic number? 

 PowerShares S&P 500 Low Volatility (SPLV) selects the 100 least volatile stocks from the S&P 500, which is itself an index of high-quality companies. SPLV then weights these 100 stocks by the inverse of volatility. SPLV does not target dividends per se, it just so happens that many dividend-paying stocks in the S&P 500 have low volatility.

 PowerShares S&P 500 High Dividend Portfolio (SPHD) contains 50 stocks from the S&P 500 that historically have produced high dividend yields and low volatility. The index ranks all of the stocks in the S&P 500 by dividend yield, then selects the 75 with the highest yield, but caps the number of stocks from any GICS sector at 10. These 75 stocks are ranked by volatility, with the 50 least volatile stocks selected for the index. Stocks are weighted by dividend yield.

 Schwab U.S. Dividend Equity ETF (SCHD) follows the Dow Jones U.S. Dividend 100 Index, a new index by Dow Jones. We mentioned before that we don't really like the dividend index from Dow Jones followed by DVY. However, this new index offers some improvements, most notably the use of a modified market-cap-weighting approach instead of a dividend-per-share weighting. It starts with the highest-yielding half of all stocks that have maintained dividends for 10 consecutive years. It then scores these stocks by cash flow/debt, return on equity, dividend yield, and dividend growth and selects the top 100 by the composite of these four metrics. At only 0.07%, SCHD is currently the cheapest of the dividend-themed funds.  Schwab (SCHW) has made it clear that they are going to keep their ETFs among the lowest-cost, and there is a lot to like about that strategy.

 ALPS Sector Dividend Dogs (SDOG) is a play on the "dogs of the Dow" theory--the idea that the highest-yielding stocks in the Dow Jones Industrial Average are likely oversold and will revert to the mean over the next year. SDOG equal weights the five highest-yielding stocks from the S&P 500 in each of the 10 GICS sectors. This results in some large sector bets against financials and in favor of utilities and telecom. The theory relies somewhat on the fact that the 30 Dow stocks are all high-quality. Applying this theory to the broader S&P 500 without some screen for quality could be risky.

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Disclosure: Morningstar, Inc. licenses its indexes to institutions for the creation of ETFs and ETNs. Morningstar receives fees that are mainly based on fund assets under management. AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Scottrade, and Van Eck currently license Morningstar Indexes. These ETFs and ETNs are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on the Morningstar Indexes.