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ETF Specialist

Weighting by Yield Can Increase Risk

While the S&P's "aristocrats" have a long track record of increasing dividends, this fund places more emphasis on higher-yielding and potentially riskier stocks.

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 SPDR S&P Dividend ETF (SDY) offers a portfolio of companies with a long track record of increasing dividends. Companies that consistently increase dividends throughout market cycles tend to have sustainable competitive economic advantages or have experienced strong growth. However, weighting these stocks by yield gives the portfolio a tilt toward lower-quality mid-cap and value companies, which may have greater risk or slower growth in the future. Since its 2005 inception, the fund has provided roughly the same return and standard deviation as a low-cost S&P 500 index fund on a pretax basis but lagged on a post-tax basis. Because of its tilt toward mid-cap and value stocks, the fund is only suitable for risk-tolerant investors or as a satellite holding as part of a diversified portfolio.

In order to limit risk, this fund selects only companies that have increased their dividends for 20 consecutive years. Still, there is no guarantee that they will continue to increase dividends in the future. At the start of 2008, right before the financial crisis, the fund had 38% of its assets in the financial sector, more than twice that of the S&P 500. Several of its largest holdings, such as Comerica, cut their dividends in 2008 and saw their stock prices crater before this fund reconstituted its holdings. After the fund was reconstituted, many of the stocks that were eliminated subsequently rebounded in 2009. 

While the fund's standard deviation has been similar to the S&P 500, other measures of risk are less encouraging. Just 30% of the stocks in the fund have a wide economic moat, compared with 47% for the S&P 500. They also have lower profitability, with a return on invested capital of 12% compared with 14% for stocks in the S&P 500, and are more reliant on debt (40% debt/capital versus 38%). The average dividend yield for stocks in the portfolio is higher than that of stocks in the S&P 500. Stocks with high dividend yields often pay out a large portion of their earnings, leaving less cash available to reinvest in the growth of their businesses. Stocks in the fund are expected to grow earnings by 8.5% compared with 9.9% for the S&P 500. Although the fund held up better than the broad market in 2008, the fund's maximum drawdown starting in 2007 was about the same as the S&P 500.

The fund returned 7.99% from November 2005 through April 2015 compared with 7.84% for the S&P 500. Yet nearly a full percentage point of that return would have been lost to taxes for a buy-and-hold investor in the highest marginal tax bracket, compared with only about 30 to 40 basis points for a competitive S&P 500 index fund. Dividend income poses two challenges relative to long-term capital gains for investors holding this fund in a taxable account. While investors can delay the realization of capital gains by deferring the sale of the fund, dividend income is taxable in the year received. Not all of the income received will be in the form of qualified dividends for tax purposes. In addition, strategic-beta exchange-traded funds such as this often have higher turnover than cap-weighted ETFs, which could trigger greater capital gains distributions. This fund has issued capital gains distributions in the past.

Fundamental View
Dividend-paying stocks have historically outperformed nondividend payers. Since 1926, stocks that pay a dividend have beaten non-dividend-paying stocks by about 1.8% annualized. Stocks in the highest yielding 30% of the market have done even better, outperforming by about 2.7% annualized. However, high-yielding stocks can be risky. While the highest-yielding 30% of the market has outperformed since 1926, these stocks have also had a greater volatility than the broader market. Stocks with the highest dividend yields are often distressed and may be offering an attractive yield as compensation for risk. Dividend-paying companies may underperform when interest rates rise. Their sensitivity to rising rates is likely due to the fact that dividend payers have less earnings growth to offset the negative impact of rising rates.

Dividends are a significant driver of total returns. Historically, dividend income has accounted for about 40% of the return from stocks, with the remainder coming from inflation, growth in earnings, and changes in the valuation multiple applied to those earnings. Changes in valuations are the least dependable source of real return. Valuations cannot rise indefinitely over the long run. Given that the current price/earnings ratio is above its long-term average, investors should not count on further expansion of the valuation multiple to drive returns. However, dividends are more reliable than multiple expansion, and companies are currently better positioned to maintain dividends than they were during the financial crisis. Dividend-payout ratios are below historic averages, and companies' cash balances are near record highs. 

Stocks in SDY offer a dividend yield of 2.8%, nearly 60 basis points greater than the S&P 500. High-yielding stocks are often distressed and trade at attractive valuations because of the market's perception that they face greater risks. Despite offering a more attractive yield, stocks in the portfolio currently trade at a price/earnings ratio of 19.6 times compared with 18.5 for the S&P 500. Back in 2005, the stocks in the fund traded at a lower price/earnings multiple than the S&P 500. The fact that dividend-paying stocks now trade at a higher relative valuation multiple could be a result of their recent popularity in the current low-interest-rate environment. Morningstar analysts cover stocks representing 75% of the assets in this fund and see it trading at a price/fair value of 0.98 compared with 0.97 for the S&P 500.

SDY's index has undergone changes in recent years. Index provider S&P overhauled the benchmark in 2012 because as SDY's assets under management grew into the billions, its trades started to affect stock prices. The financial crisis also winnowed the eligible universe to a very narrow group. Previously, the index capped the number of constituents at 60 and required companies to increase their dividends for 25 years. The index's size and liquidity screens allowed thinly traded micro-cap stocks into the fund as well. The methodology change doubled the minimum size and liquidity requirements, lowered the mandatory years of dividend increases to 20, and removed the cap on the total number of constituents. These changes should help reduce portfolio turnover.

Despite these changes, SDY's large asset base along with the fact that it owns some mid- and small-cap stocks can cause it to own large positions in individual stocks. Currently, the fund has 2% of its assets in  People's United Financial (PBCT), making it the largest owner of the stock with 6% of its outstanding shares. Because passive funds do not conduct traditional fundamental analysis, outsized holdings of individual stocks raise concerns. During the past year, the fund has lagged its benchmark by more than its expense ratio, a sign of high trading costs or poor index fund management.

Portfolio Construction
SDY tracks the S&P High Yield Dividend Aristocrats Index, which screens for stocks from the S&P Composite 1500 that have increased their dividends for the past 20 consecutive years. Constituents must also meet a minimum float-adjusted market-capitalization hurdle ($2 billion) and a liquidity hurdle (an average daily volume of at least $5 million). Stocks that pass these screens are weighted by their indicated annual dividend yield, capped at 4% of the index. The index is reconstituted once a year in January and rebalanced quarterly. Yield-weighting results in a tilt toward smaller-cap and value stocks. While the fund currently resides in the large-value Morningstar Category, it can shift to large blend or mid-cap value. Sector exposure can vary widely from the market and over time. The fund has 51% of its assets in mid- and small-cap stocks, compared with just 13% for the S&P 500. At $19 billion, the average market cap is well below the $73 billion average market cap of the S&P 500. The fund currently has large overweightings in basic materials and industrials and underweightings in health care and financial services. Turnover has been elevated relative to market-cap-weighted strategies and hit 105% in 2009 as dividend cuts forced the index to replace many of its holdings.  

Fees
This fund charges a 0.35% expense ratio. While that is low compared with the average mutual fund fee, a number of dividend-themed ETFs are available for less than 0.20%. 

Alternatives
Investors have more than 30 dividend ETFs to choose from. Like SDY,  Vanguard Dividend Appreciation (VIG) also looks for stocks with a long history of increasing dividends, but by weighting them by market capitalization rather than yield, it maintains a higher-quality and wider-moat portfolio. Those looking for a higher yield than what VIG offers might consider  Vanguard High Dividend Yield (VYM), which screens for dividend-paying stocks but holds a much larger swath of the market than SDY and market-cap weights its holdings. Both VIG and VYM charge 0.10%.

 Schwab U.S. Dividend Equity (SCHD) (0.07% expense ratio) is the cheapest in the group. The fund owns 100 stocks that have paid dividends for 10 years and rank well according to several fundamental ratios (cash flow/debt, return on equity, dividend yield, five-year dividend growth). It weights its holdings by market capitalization. The result is a high-quality portfolio with a competitive yield.

 WisdomTree MidCap Dividend (DON) (0.38% expense ratio) screens for dividend-paying mid-cap stocks and weights them by the dollar amount of dividends paid rather than by yield. This results in a similar mid-cap value tilt to SDY, but with more than 400 stocks, it is more diversified.

 


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Michael Rawson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.