An Elegant and Transparent Dividend-Focused Strategy

I recently highlighted several funds that paid the price for chasing high-dividend-yielding stocks in an article titled "The Perils of Funds That Narrowly Target High-Yielding Stocks."

Putting too much emphasis on dividend yield can harm the total

your equity-income investment. It's important to focus on an investment's prospective total return--not solely its yield--as higher yields usually imply greater risk.

For example, high-yielding stocks could be under financial distress and thus may be more likely to cut their dividend payments than their lower-yielding counterparts. And many high-yielding stocks pay out a large share of their earnings as dividends, leaving a small buffer to cushion these payments if their business deteriorates.

SPDR S&P Dividend ETF tracks the S&P High Yield Dividend Aristocrats Index, which includes stocks from the S&P 1500 Composite Index that have increased their dividend payment for at least 20 consecutive years. The fund's focus on firms that are financially healthy enough to grow their payouts favors profitable companies with durable competitive advantages. And the fund finds yield. Its average dividend yield has measured about 30% higher than that of the Russell 1000 Value Index since the fund's inception in November 2005.

The fund's lengthy dividend-growth look-back leads to persistent sector bets compared with its Morningstar Category. For instance, during the past decade, the fund's energy sector exposure has measured a fourth of the category average and its materials sector weighting triple the category's. And given their dividend payment stability, the fund persistently has greater exposure to the utilities and real estate sectors. Because the fund selects holdings from a broader selection universe and weights its holdings by their dividend yield, its average market capitalization is smaller than its category average. As of October 2017, its average market cap measured $20 billion, less than half that of its category.

Despite its smaller market capitalization, the fund's tilt toward more-stable stocks has helped it shine during market downturns. It held up better than the Russell 1000 Value Index and landed in the top quartile of the large-value category during the market drawdown from October 2008 to March 2009. The fund outpaced its category by 3.2% during the trailing 10 years through October 2017, primarily because of greater exposure to

stocks, smaller exposure to energy stocks, and more favorable stock exposure within the financial sector.

Fundamental View In a theoretical frictionless market, dividend payout policy shouldn't impact stock returns (for further reading, see the Modigliani-Miller Theorem). A dividend payment should reduce the firm's stock price by an offsetting amount. But in practice, dividends often matter because they can impose greater discipline on managers in their capital-allocation decisions, leaving less money for low-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.

Investors can benefit from owning dividend-paying stocks, but chasing yield can be dangerous. The highest-yielding stocks could be under financial distress and more likely to cut their dividends than their lower-yielding counterparts. Many of these stocks pay out a large share of their earnings as dividends, leaving a small buffer to cushion these payments if their business deteriorates. This fund strives to mitigate this risk two ways. First, it selects its holdings from stocks that have increased their dividend payout for 20 consecutive years. Second, it caps individual stock weightings at 4% of its portfolio at its quarterly rebalance. If a stock is more profitable, it should be able to maintain its dividend during a market downtown or raise its payout ratio in the future.

Like most dividend-oriented strategies, this 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 invest aggressively to expand. Both characteristics can lead to higher dividend yields. Not surprisingly, the fund's holdings were expected to pay out a larger share (59%) of their earnings as dividends at the end of October 2017 than the Russell 1000 Value Index (46%), based on calculations from earnings and dividend forecasts presented in Morningstar Direct.

The fund's 20-year dividend-growth requirement is a tough hurdle to clear. If a company doesn't continue to raise its dividend, it is out for at least 20 years. 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 them. Top holdings currently include

The fund's dividend growth requirement and portfolio weighting approach lead to persistent sector bets. Compared with the large-value category, the fund has larger stakes in the utilities, real estate, and consumer staples sectors and smaller exposure to the healthcare, technology, and financial sectors. The fund's value and profitability tilts should continue to influence its performance. Both characteristics have been associated with higher returns over the long term, but they don't always pay off.

Portfolio Construction The fund targets U.S. stocks with a long history of raising their dividend payments. It mitigates the risks associated with narrowly targeting high dividend yields by balancing dividend growth with yield and capping single-stock weightings. It earns a Positive Process Pillar rating.

The fund 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 minimum market-cap ($2 billion) and liquidity (an average daily volume of at least $5 million) hurdles. Stocks that pass these screens are weighted by their indicated annual dividend yield, capped at 4% of the index. S&P reconstitutes the index once a year in February and rebalances it quarterly. Yield-weighting results in a tilt toward smaller-cap and value stocks. While the fund currently resides in the large-value category, it can shift to the large-blend or mid-value categories. Turnover tends to be higher than that of market-cap-weighted strategies and can rise following dividend cuts, as was the case in both 2009 and 2012. In recent years, turnover has been close to 30%.

S&P changed the index's process for the better during the summer of 2012. Previously, the index required 25 years of dividend payment history and selected only the top 50 stocks by their dividend yield. S&P also upped the minimum market cap and liquidity hurdles at this index change.

Fees State Street charges a 0.35% expense ratio for this fund. This fee is a fraction of the 0.90% median levy of the fund's large-value peers. It earns a Positive Price Pillar rating.

While less-expensive dividend-targeting index options are available, the fund's fee still scores in the lowest third of index mutual funds and exchange-traded funds in the category. Over the trailing three years ended October 2017, this fund lagged its benchmark by 0.4% per year, slightly higher than its average annual fee over this time frame.

Alternatives

Silver-rated

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

for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets,

or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.