Dividend Index Construction Shouldn't Be an Afterthought

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Adam McCullough. He is a manager research analyst here at Morningstar. We are going to talk about how index construction can make a big difference in performance.

Adam, thanks for joining me.

Adam McCullough: Thanks for having me today, Jeremy.

Glaser: You recently wrote a great article about how two dividend ETFs that seemed very similar have had very different performance because of relatively small differences in their composition. Could you walk us through what these two funds are?

McCullough: I looked at two funds; Vanguard Dividend Appreciation, VIG, and Invesco Dividend Achievers, PFM. These two funds have very similar index construction approaches. But over the long haul, from May 2006 through September 2018, the Vanguard fund has actually outpaced the Invesco Dividend counterpart by about 1.9 percentage points annualized over that time frame.

Glaser: What are some of those differences in index construction?

McCullough: These two funds actually make a great case study because, one, they have had a long history of live performance; and two, they start with identical index construction. What these funds both do is they are both looking for U.S. dividend payers. They both look for U.S. dividend payers that have paid dividends consistently and grown them for at least 10 years. They market-cap-weight those stocks to meet that hurdle, and then they cap the maximum weight of any single holding to only 4%. Up to now, both of these funds are on par with that kind of construction methodology.

The Vanguard fund goes a step further. What this fund does is, first, it excludes REITs, or real estate investment trusts, also LPs or limited partnerships, and it applies a proprietary profitability screen. You can take out stocks that maybe don't have the cash flow to cover their dividend payments ahead of when they might actually cut their dividend payments, and that's also key. The Vanguard fund can remove stocks as soon as they don't start meeting its profitability criteria, whereas the Invesco fund has to wait for a stock to cut its dividend by at least half or all the way before it can remove from the index and they can only do so at the end of the month.

Glaser: Do you have an example of how the funds' performance diverge because of these rules differences?

McCullough: The key here is the interaction of the Vanguard fund to apply this profitability screen when it feels necessary to. For instance, during the financial crisis, the Vanguard fund was able to step out of financial services stocks as their fundamentals and cash flows were falling, and they weren't going to be able to meet their dividend payments. It was actually able to have a slightly shallower drawdown at 46.6% versus the Invesco fund drawdown of about 53.3%. This allowed the fund to, one, recover faster, and two, just be able to avoid also future instances where certain sectors or stocks maybe didn't have the cash flow to cover dividend payments, but it was able to move out of the way before that actually hit the performance of the portfolio.

Glaser: Looking at bigger lessons for investors then, if you are going to go outside of a market-cap-weighted index, what's the right way to assess or what's the right way to think about these different index rules?

McCullough: As always, the important thing is to know what your risk profile is, what your goal is for the investment. Once you start with that, is to look at the index construction methodology of the fund--how is it constructed, what kind of constraints are in place, what is it targeting. Two, how is that construction going to translate to a portfolio--what kind of characteristics will the fund have given its construction. Three, ultimately, is the performance--how will these characteristics of the portfolio translate to investor performance.

What we try and do in the Morningstar ETF report is really look at, one, the construction methodology and give our opinion on it; two, how will that translate to a portfolio of stocks; and three, how will that ultimately get you to the performance that we expect from that type of portfolio.

Glaser: Adam, I appreciate the insight today.

McCullough: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.