There's Value in This High-Dividend ETF

High-yielding stocks tend to pay out a larger share of their earnings than average, leaving a smaller buffer to preserve dividend payments should earnings fall. And some of the highest-yielding stocks may face financial distress. Indeed, the fund has invested in some stocks that have cut their dividends, like

Because investors often punish firms that cut their dividends, most managers only commit to payments that they are reasonably confident they will be able to honor over the full business cycle. Therefore, firms with more-stable cash flows and stronger profitability are more likely to pay dividends. Dividend payments can even improve profitability by constraining managers from investing in low-return projects. This can help explain why the fund's holdings are more profitable on average than those in the Russell 1000 Value Index and why it was less sensitive to market fluctuations since its inception in November 2006.

Despite taking less market risk and exhibiting slightly lower volatility than the Russell 1000 Value Index, the fund outpaced this benchmark by 1.6 percentage points annually from its inception in November 2006 through May 2016. This was due to its greater exposure to consumer defensive stocks, smaller exposure to financial-services stocks, and differences in stock holdings within several sectors.

Fundamental View In theory, a dividend-payout policy should not influence stock values (for further reading see the Modigliani-Miller Theorem). But in practice, dividends can matter because they can impose greater discipline on managers in their capital-allocation decisions, leaving less money for lower-return investments. And managers may use these payments to signal their confidence in their firms' prospects. Dividends can also help address some behavioral issues, including many investors' reluctance to realize capital gains to meet income needs and may give them the fortitude to weather market volatility. But they can be less tax-efficient than capital gains because investors do not have the option to defer the associated tax liabilities.

Like most strategies that focus on dividend yield, the fund has a pronounced value tilt. Mature, slow-growing firms tend to trade at lower valuations and pay out a larger share of their earnings as dividends than their faster-growing counterparts, which are investing more aggressively to expand. Both of these characteristics can lead to higher dividend yields.

This portfolio looks and behaves differently from traditional value benchmarks, like the Russell 1000 Value Index. Most notably, it has much greater exposure to the consumer defensive sector and less exposure to financial-services stocks. Not surprisingly, the fund's holdings were expected to pay out a larger share (62%) of their earnings as dividends at the end of May 2016 than the Russell 1000 Value Index (48%), based on consensus forecasts presented in Morningstar Direct. They also generated a higher average return on invested capital (10.9%) than those in the index (6.1%) over the trailing 12 months through May 2016. High profitability, coupled with conservative capital investment and low valuations, should allow the fund's holdings to offer high free cash flow returns on capital.

The fund's value and profitability tilts will likely continue to influence its performance. Both of these characteristics have been associated with higher returns over the long term, but they don't always pay off. For instance, in the United States, value stocks have lagged their growth counterparts over the fund's life, which detracted from its performance. But its profitability tilt gave it a small return boost.

Market-cap weighting tilts the portfolio toward the largest dividend stocks, which are not necessarily the highest-yielding. But this approach limits the fund's exposure to the riskiest dividend payers and reflects the market's view about the relative value of its holdings. It also helps keep turnover low. In fact, turnover fell below 20% in each of the past five years, and the composition of the portfolio has been fairly stable. The fund does not remove stocks before they cut their dividends, unless such cuts are reflected in the third-party dividend forecasts it uses to select stocks.

Portfolio Construction The fund employs full replication to track the FTSE High Dividend Yield Index. The selection universe consists of all U.S. dividend payers, excluding REITs, from the FTSE All-World Index, which includes large-, mid-, and some small-cap stocks. FTSE ranks all stocks by their 12-month forward dividend yield, based on Institutional Brokers Estimate System forecasts, and selects the highest-yielding names for inclusion until the portfolio represents about half of the selection universe's market capitalization. It weights these holdings according to their market capitalization. In order to mitigate turnover, constituents may stay in the index as long as they fall in the highest-yielding 55% of the selection universe by market capitalization. New stocks will only be added once they break into the highest-yielding 45% of the investable universe. The index is reviewed semiannually.

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