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ETF Specialist

A Growth-Oriented Foreign Dividend Fund

Vanguard International Dividend Appreciation employs strict selection criteria to focus on high-quality stocks.

High-quality companies often have a defensive bent, making them a welcome addition to a diversified portfolio. They tend to exhibit lower volatility than the market and hold up better during drawdowns. Consistent dividend growth is a good proxy for quality because it demonstrates that the business is healthy and stable, and is run by a shareholder-friendly management team.  Vanguard International Dividend Appreciation ETF (VIGI) seeks out these stocks outside the United States.

VIGI is poised for success over the long term. This low-cost fund prioritizes dividend growth over yield, which emphasizes highly profitable firms that should hold up better than most during market downturns and offer attractive long-term returns. However, its short track record limits its Morningstar Analyst Rating to Bronze.

The fund invests in large- and mid-cap stocks from developed and emerging markets, and targets those that have increased their dividend payments for seven consecutive years. It then applies additional filters to eliminate stocks that may not be able to sustain their dividend growth. The portfolio weights its holdings by market capitalization to help mitigate turnover and trading costs. Individual stocks are limited to 4% of the portfolio at the annual rebalance to improve diversification.

Many foreign stocks tie their dividend payments to earnings. Therefore, companies that have a history of increasing their dividend payments are also likely to be those that have been consistently growing profitably. These stable businesses should be less volatile than the broader market and are likely to hold up better during market downturns.

Screening for stocks with seven years of dividend growth is a strict hurdle. This criterion captures companies that not only have the capacity to make dividend payments but also a willingness to do so. However, it does not look at other metrics, such as debt levels and analyst earnings growth estimates, which may be indicative of a firm’s capacity to continue making payments. Additionally, if a company were to miss a single dividend payment it must wait seven years before being welcomed back.

This fund was launched in February 2016 and has not had sufficient time to build a meaningful record. It should hold up better than many of its Morningstar Category peers when the broader market goes through a downturn but lag during periods of strong performance. Its risk-adjusted returns were in the bottom third of the category between March 2016 and May 2018.

Fundamental View
This strategy focuses on dividend growth, which emphasizes companies that tend to be more stable than the broader market. Strategies that invest in highly profitable companies have sound investment merit. In his 2012 paper “The Other Side of Value,” Robert Novy-Marx demonstrated that profitable firms have historically outperformed unprofitable firms and are less prone to distress.

The fund requires constituents have at least seven consecutive years of increased regular dividend payments. This is somewhat relaxed from the U.S. version of this strategy,  Vanguard Dividend Appreciation ETF (VIG), which requires 10 years of increased payments. The reduced hurdle was necessary because foreign companies typically tie their dividend payments to earnings, making payments more volatile than those from U.S. companies. As a result, fewer companies would be able to pass a 10-year growth screen. While the fund’s seven-year requirement is slightly less demanding, it improves diversification.

Firms that make the cut tend to be more profitable and generate more consistent earnings growth than average. As a result, this fund is skewed toward those from stable sectors such as consumer staples. Top holdings include major multinational firms including  Nestle SA (NSRGY), L’Oreal (LOR), and  Unilever (UL). Companies like these tend to be less volatile than the broader market and should hold up better during market downturns. The holdings in this fund are also weighted by market capitalization, which emphasizes the largest companies that have consistently raised dividends, many of which have globally diversified revenue streams. The average market capitalization of this fund’s holdings is one of the largest in the foreign large-growth category.

This fund’s focus on dividend growth makes it significantly different from those that emphasize dividend yield. A narrow focus on yield brings about certain risks because high yields can be an indicator of firms that may be in financial distress or have poor forward-looking prospects. These stocks trade at lower prices relative to dividends paid and can be risky. Other high-yielding stocks may be paying out a large fraction of their earnings. These companies may be at risk of cutting their dividends because increasing payments in the future is unsustainable. Funds that hold these stocks tend to be more value-oriented and more volatile than a broad market-cap-weighted index.

About one fourth of this portfolio is invested in emerging-markets stocks. These holdings can be subject to various risks that threaten business growth and stability, making them more volatile than their developed-markets peers. These include poorly maintained infrastructure and undeveloped regulatory systems.

Portfolio Construction
This fund tracks the Nasdaq International Dividend Achievers Select Index, which targets companies that have a strong history of raising their dividend payments. Its market-cap-weighted approach further emphasizes large stable firms while mitigating turnover and trading costs, and supports a Positive Process rating.

The selection universe for this index starts with stocks listed in the Nasdaq Global Ex-U.S. Index and includes those listed in both developed and emerging markets. The process excludes REITs and companies that are currently working through bankruptcy proceedings. It applies additional liquidity screens to ensure potential holdings are investable. The methodology further narrows down its selection to companies that have a seven-year history of increasing regular dividend payments. Nasdaq applies some additional proprietary filters intended to improve the fund’s chances of holding companies that will continue to grow their dividends. Stocks that meet these criteria are weighted by market capitalization, subject to a 4% maximum weighting at the time of the rebalance. The index is reconstituted annually in March, and the managers use full replication to fulfill their index-tracking objective.

Vanguard offers this fund through three share classes. It charges 0.35% for the Investor shares, while Admiral shares and the ETF both cost 0.25%. These fees all land in the bottom decile of the foreign large growth Morningstar Category, and earn a Positive Price Pillar rating. Investor shares have a $3,000 investment minimum and Admiral shares require $10,000. The Investor and Admiral shares also charge a 0.25% purchase and redemption fee. The total returns of the Admiral share class lagged its target index by 0.27% annually between Feb. 26, 2016, and May 2018, an amount comparable to its expenses.

IShares Edge MSCI International Quality Factor ETF (IQLT) (0.30% expense ratio) goes after high-quality firms listed in foreign developed markets. Unlike VIGI, it doesn’t look for dividend growth directly, but instead screens for stocks with high return on equity, low debt/equity, and low volatility in annual per-share earnings growth. IQLT’s portfolio looks considerably different from VIGI’s. In fact, only 25% of IQLT’s portfolio overlaps with VIGI's, but both funds should offer a smoother ride than the broader market.

 WisdomTree International Hedged Quality Dividend Growth ETF (IHDG) (0.58% expense ratio) takes a different approach. It relies on forward-looking earnings growth estimates and profitability metrics to target dividend-paying stocks with strong dividend growth potential. However, it does not consider managements’ willingness to raise their dividends. The managers weight their holdings by dividend payments. They use forward contracts to hedge away foreign exchange risk.  WisdomTree International Quality Dividend Growth ETF (IQDG) follows the same strategy as IHDG, but charges 0.38% and does not hedge currency risk.

IShares Edge MSCI Minimum Volatility EAFE ETF (EFAV) (0.20% expense ratio) and  iShares Edge MSCI Minimum Volatility Emerging Markets ETF (EEMV) (0.25% expense ratio) are two funds that could be used to construct a portfolio that covers the wider foreign stock market. These funds use an optimizer to select and weight stocks in a way that minimizes expected volatility. As a result, these funds tend to hold a lot of large, profitable firms that should offer a smoother ride than the market. EFAV and EEMV both have Silver ratings.

Daniel Sotiroff has a position in the following securities mentioned above: VIG, VIGI. Find out about Morningstar’s editorial policies.