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ETFs

Not All Dividend ETFs Are Created Equal

It's important to look beyond these funds' label and understand what is in the tin.

A version of this article appeared in the July 2017 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.

Exchange-traded products that are labeled with the "dividend-screened/weighted" attribute within Morningstar's strategic-beta taxonomy represent the largest contingent of this universe as measured by assets under management. As of the end of May 2017, these funds collectively held $162 billion of investors' assets. This represents 26% of the $620 billion in the broader strategic-beta group.

This group has been growing at a blistering pace in recent years. During the trailing decade, dividend-oriented ETPs have attracted nearly $117 billion in new assets.

This should come as little surprise in the context of the prevailing interest-rate regime and the secular upward trend in demand for sources of investment income, as the first waves of baby boomers have entered retirement.

Asset managers have taken notice, and product proliferation is in full swing. Of the 158 dividend-screened/weighted ETPs that exist today, more than half are less than five years old (see Exhibit 2). As the menu of dividend-oriented ETPs expands, it is important that investors understand that not all dividend ETPs are created equal. Each has its own unique characteristics, which stem from important--albeit often nuanced--differences in the methodologies of their underlying benchmarks. Understanding three key characteristics of these funds can help investors make more-informed choices. To help you better discern the distinctions between these funds, I will focus on three specific characteristics: dividend yield, dividend growth, and dividend sustainability.

Dividend Yield A fund's current dividend yield is often the first metric investors seek out when shopping for equity-income opportunities. The 12-month-yield metric aggregates an ETP's distributions during the trailing 12 months and then divides that figure by the fund's net asset value. While this metric is interesting, it is not very useful in isolation. This is because it lacks context.

Framing a fund's 12-month yield in the context of its historical values and relative to the current and historical values for comparable strategies provides useful context. For example, in Exhibit 3, I plotted the current, average, maximum, minimum, and 75th and 25th percentiles of the monthly 12-month yields for dividend exchange-traded funds that invest in U.S. large caps and that launched before 2007. I also included

It is readily apparent, based on a passing glance at this exhibit, that these funds' yields can be quite volatile over time. It's also obvious that these funds' yields can diverge from one another in dramatic fashion. At the end of February 2008, the highest-yielding fund of the lot,

Dividend Growth Investors too often look at dividend yields in isolation, without giving dividend growth its due. Dividend growth is a vital component of the overall income equation, as it will determine the extent to which the expansion of an investor's equity-income stream will lag, keep pace with, or outstrip the rate of inflation. The goal, of course, is to grow this income stream at a rate that exceeds inflation, in order to grow one's real (that is, inflation-adjusted) income.

Of the 10 dividend-oriented ETFs included in the sample, five of them track a benchmark that specifically screens its investable universe for firms with long track records of paying and/or regularly increasing dividends.

Dividend Sustainability Perhaps even more important than dividend growth is the overall stability of a dividend-oriented ETP's income stream. After all, investors looking to these funds as a source of cash flow would be disappointed to find that their income stream is volatile and may be devastated if they were to take a substantial pay cut.

The financial crisis provided a test case for these ETFs, putting the dividends of the stocks they owned under extreme pressure. For each of the funds in my sample, I calculated what I'll refer to as their maximum dividend drawdown: the largest year-on-year decline in their annual dividend payment, which in every case took place in 2009. Unsurprisingly, four of the five ETFs whose benchmarks specifically screen their constituents on the basis of a steady history of paying and growing dividends had, on average, relatively muted dividend drawdowns relative to their peers.

Putting It All Together In Exhibit 5, I put it all together. The ETFs included are the same as those referenced above. Once again, I've included dividend-screened/weighted ETFs that invest in U.S. large caps and and launched prior to 2007. I also included SPY as a point of reference. In the table, I've listed these funds' 12-month yields as of the end of May 2017, the maximum year-on-year drawdown of their annual dividend, the trailing three- and five-year compounded annualized growth of their dividends, and their expense ratios. The composite score in the far right-hand column is a simple sum with a maximum value of 5. If an ETF has an above-average current yield, a below-average maximum dividend drawdown, above-average dividend growth during the trailing three- and/or five-year periods, or a below-average fee, it earns a point. I ranked the ETFs in this group in descending order on the basis of their composite scores.

The ranking in Exhibit 5 gives a back-of-the-envelope assessment of the recent historical performance of the most-tenured members among the current crop of dividend-oriented ETPs. It is not meant to be a comprehensive list of best-of-breed funds--especially as it excludes many newer entrants that also dabble in U.S. large caps. What it does provide is a useful guide for conducting your own due diligence. Specifically, investors mulling an allocation to a dividend ETP should consider the following:

1 | Price Fees are the most stable, explicit, and predictable detractor from future performance and will come directly off the top of an investor's income stream. Look for low-cost funds.

2 | Yield Do not consider yield in isolation. Rather consider it in its historical context, how its stacks up relative to peers, and how it springs forth from the underlying index methodology.

3 | Growth Look for funds that can grow their dividends at an inflation-plus rate over the long haul. Benchmarks that specifically screen on the basis of historical and/or prospective growth should have better odds of growing their income streams over time. They tend to invest in firms that boast wider economic moats, which are sustainable competitive advantages that manifest in strong and stable profits.

4 | Stability Investors should place a premium on income stability, particularly in bear markets. On average, the ETPs in the sample I studied that are based on benchmarks that specifically screen their investable universe for growing and/or stable dividends fared better during the financial crisis, experiencing relatively muted dividend drawdowns versus their peers.

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

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