Where there’s yield, there’s usually risk. Many of the highest-yielding stocks have poor growth and pay out a large share of their earnings as dividends, leaving a small buffer to cushion dividends if their earnings fall. So, aggressively chasing yield isn’t prudent. However, income investors can keep risk in check through broad diversification or by screening out the riskiest names. Invesco S&P 500 High Dividend Low Volatility ETF (SPHD) relies primarily on the latter approach. It earns a Morningstar Analyst Rating of Bronze.
The fund prioritizes dividend yield over low volatility. It starts with the 75 highest-yielding stocks in the S&P 500. To limit risk, the fund ranks all stocks that pass its initial screen on their volatility over the past year and removes the most volatile 25. Volatility isn't a perfect measure of risk, but less-volatile stocks tend to have more-stable cash flows than their more-volatile counterparts and generally hold up better during market downturns.
Stocks that make the cut are weighted by dividend yield, although the fund caps these weightings at 3% to improve diversification. So, although the fund only includes 50 stocks, it has limited exposure to stock-specific risk. However, it does not limit its sector weightings, resulting in large tilts toward the real estate, utilities, and consumer defensive sectors. The portfolio lands in large-value territory. It has a higher dividend yield and smaller market-cap orientation than the Russell 1000 Value Index.
Despite its volatility screen, the fund has exhibited comparable volatility to the S&P 500. That's because its focus on dividend yield pulls it toward some of the riskier names in the index to begin with, which its volatility screen helps offset. That said, the fund exhibited low sensitivity to market fluctuations (market beta of 0.66) from November 2012 through October 2018. This suggests that the fund had considerable exposure to risk that is not highly correlated with the market. During that time, the fund outpaced the Russell 1000 Value Index by 71 basis points annualized. This was largely due to more-favorable exposure to consumer defensive stocks.
Dividends can benefit investors by imposing greater discipline on managers in their capital-allocation decisions, leaving less money for lower-return investments. These payments 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 of deferring the associated tax liabilities.
Like most strategies that focus on dividend yield, the fund has a 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 characteristics can lead to higher dividend yields.
Without any adjustments, the fund's aggressive pursuit of yield could give it an elevated risk profile, as some of the highest-yielding names have unattractive business prospects and may not be able to sustain their dividend payments. While the fund does not screen for dividend sustainability, its volatility filter helps reduce risk. Firms that have exhibited high volatility in the recent past tend to have more-volatile cash flows and more-uncertain prospects than their more-stable counterparts. And they generally don't do as well during market downturns. Removing these firms should cut the fund's downside risk.
This compact portfolio looks and performs quite differently than the Russell 1000 Value Index. In fact, its correlation to that index was only 0.74 from November 2012 through October 2018. Yield weighting gives the fund a smaller market-cap orientation than the Russell 1000 Value Index. Sector weightings here also look quite different from the benchmark's. For example, because utilities stocks generally offer high yields and exhibit low volatility, they carry more than three times the weighting in this portfolio than they do in the index, which is a source of risk. The fund also has greater exposure to real estate and consumer defensive stocks than the benchmark, and less exposure to the financial-services and healthcare sectors.
The portfolio's turnover was close to 50% in each year from fiscal 2013 through 2017. While relative yields and volatility tend to persist in the short term, they are not stable, which will create turnover. Yield weighting contributes to the fund's turnover because yields tend to move in the opposite direction of market prices, requiring rebalancing to reset the target weightings. This also deepens the fund's value tilt by forcing it to increase its exposure to stocks that haven't appreciated as much as their peers, and to trim its exposure to names that have become more expensive when it rebalances.
The fund effectively offers diversified, risk-controlled exposure to high-dividend-paying stocks. But it can take large sector bets, which are sources of risk that limit the Process rating to Neutral.
The managers employ full replication to track the S&P 500 Low Volatility High Dividend Index. This index ranks all stocks in the S&P 500 by their 12-month-trailing dividend yields (excluding special dividends) and screens for the 75 highest-yielding names. It won't admit any more than 10 stocks from the same sector. It then ranks these stocks on their realized price return volatility over the prior 12 months and targets the 50 least-volatile names. Stocks that make the cut are weighted by dividend yield. However, the index limits individual stock weightings to 3% of the portfolio and sector weightings to 25% to better diversify risk. S&P refreshes the portfolio twice a year in January and July. There are no constraints on turnover or buffer rules in place to mitigate unnecessary turnover, which is a small drawback. That said, the fund's holdings are very liquid and should be cheap to trade.
Invesco charges a 0.30% annual fee for this offering, which is low relative to its actively managed counterparts in the large-value Morningstar Category and competitive with other dividend-oriented index funds. Therefore, it earns a Positive Price Pillar rating. However, there are considerably cheaper options available, such as Vanguard High Dividend Yield ETF (VYM), which charges a 0.08% expense ratio. Over the trailing three years through October 2018, the fund lagged its benchmark by 37 basis points annualized.
Legg Mason Low Volatility High Dividend ETF (LVHD) (0.27% expense ratio) is the closest alternative. It targets high-dividend-paying U.S. stocks across the entire market-cap spectrum, penalizing the more-volatile names with lower weightings. To promote dividend sustainability, qualifying stocks must have dividend payout ratios of less than 100%.
Silver-rated VYM is one of the lowest-cost and most compelling dividend-strategy funds available. It targets stocks representing the higher-yielding half of U.S. dividend-payers, excluding real estate investment trusts, and weights its holdings by market cap. This produces a well-diversified, low-turnover portfolio with a larger market-cap orientation than SPHD. The benchmark it tracks has been tough to beat over the long term.
Vanguard Equity-Income (VEIPX) is a competitively priced actively managed alternative. Its Investor shares charge a 0.26% expense ratio. Michael Reckmeyer of Wellington Management runs about two thirds of the portfolio, while Vanguard's in-house quantitative equity group manages the remainder. Reckmeyer looks for stocks with high yields and undervalued growth prospects. The quantitative group selects stocks from VYM's index that have attractive valuations, momentum, earnings sustainability, and payout policy. This is a reasonable hands-on strategy that has a low fee hurdle to overcome. It carries a Silver rating.
Alex Bryan, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.