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ETF Specialist

A Dividend-Growth Fund to Ride Out Market Downturns

This exchange-traded fund targets high-quality stocks that can sustain or grow their dividend payments.

Dividend-growth funds focus on companies that have the ability and willingness to increase their dividend payments. Companies that regularly boost their dividends often have sustainable competitive advantages. Such high-quality companies can make excellent core holdings. Quality-focused stocks may not keep pace during bull markets, but they hold up well in down markets to earn their keep.  Vanguard Dividend Appreciation ETF (VIG) is an excellent fund that offers a diversified portfolio of highly profitable U.S. dividend-paying stocks. The fund's low fee contributes to its edge over the long run and supports its Morningstar Analyst Rating of Gold.

This strategy focuses on dividend growth rather than dividend yield. This approach reduces the fund's exposure to firms with weak fundamentals that may not be able to sustain their dividend payments, which is a risk that often accompanies a narrow focus on yield. The fund builds its portfolio by selecting only among stocks that have increased their dividend payment for at least 10 consecutive years. This stringent hurdle restricts the fund to holding highly profitable firms with shareholder-friendly management teams that have consistently raised dividend payments.

On top of this dividend-growth screen, the strategy applies additional proprietary screens to filter out firms that may not be able to sustain their dividend growth. It weights its holdings by market capitalization, which helps further keep risk in check. Market-cap-weighting tilts the portfolio toward the largest dividend-paying stocks, which may not be the highest-yielding. Bigger firms should be better able to maintain their dividend payments during a market downturn than smaller, higher-yielding stocks. Market-cap-weighting also incorporates knowledge of the market and reduces the fund's exposure to stocks as their fundamentals deteriorate. The portfolio caps single-stock bets, which are usually uncompensated sources of risk.

As of this writing, the strategy's dividend yield of 2 percentage points annually matches the dividend yield of the Russell 1000 Index. But the strategy's tilt toward more-stable stocks has helped it shine during market downturns. Its drawdown during the bear market from October 2007 through March 2009 measured 9 percentage points less than the Russell 1000 Index's drawdown.

The fund outpaced its average large-blend Morningstar Category peer by 1.6% and kept pace with the Russell 1000 Index since its inception in May 2006 through March 2019 with less risk.

Fundamental View
Don't expect high yield from this fund because it's focused on dividend growth. Most dividend-themed funds end up with a value tilt because they explicitly target stocks with higher dividend yields, but this fund falls in the large-blend category and has a dividend yield in the same ballpark as the Russell 1000 Index. That's because this fund pursues stable, profitable names with a higher potential of raising their dividend payments, rather than targeting stocks with high dividend yields.

This fund only considers stocks for its portfolio that have raised dividend payments consistently for at least a decade. This screen is backward-looking, so it doesn't guarantee that a stock will maintain its dividend payment, but it demonstrates a commitment of returning cash to shareholders. Lengthy backward-looking hurdles, like this one, preclude companies like  Apple (AAPL) that have the financial means to sustain or grow their dividend payment but initiated the payment less than 10 years ago.

The index uses profitability screens to avoid stocks with deteriorating fundamentals. If a stock is more profitable, it should be able to maintain its dividend during a market downturn or raise its payout ratio in the future. For instance, this fund dropped  ConocoPhillips (COP) from its portfolio before the stock cut its dividend payment in early 2016. Many of its dividend-oriented peers that rely only on backward-looking dividend-sustainability metrics still held ConocoPhillips when it cut its dividend payment.

Because the fund targets mature dividend-payers and weights them by market cap, it favors larger stocks with sustainable competitive advantages. As of this writing, about three fourths of its holdings earn Morningstar Economic Moat Ratings of wide compared with just half for the Russell 1000 Index.

The portfolio caps single-stock weightings at 4% of the portfolio at each quarterly rebalancing. This helps mitigate the risk of a handful of stocks dominating the portfolio.

The fund's 10-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 a decade. This can lead to large sector bets. The fund currently does not own any energy stocks, and its industrials and consumer staples sector weightings are double those of the category index.

The fund's tilt toward more-stable stocks has helped it shine during market downturns. Its drawdown during the bear market from October 2007 through March 2009 measured 9 percentage points less than the Russell 1000 index.

Portfolio Construction
The fund targets profitable dividend-paying U.S. stocks with a history or raising their dividend payments. This results in a well-diversified portfolio of dividend-paying stocks with durable competitive advantages and shareholder-friendly management teams that should weather market downturns better than most and reward investors over the long haul. It earns a Positive Process Pillar rating.

The fund replicates the Nasdaq US Dividend Achievers Select Index. This is a subset of the Nasdaq US Broad Dividend Achievers Index, which holds U.S. stocks that have grown their regular dividend payment for at least 10 consecutive years. From this broader list of stocks, the fund excludes REITs and limited partnerships and applies proprietary profitability screens to land on its final list of constituents. While Nasdaq does not disclose its screens, these filters seem to favor profitable companies with stable earnings. The fund weights its holdings by market cap, and individual positions are capped at 4% of the portfolio. The index reconstitutes annually in March, but stocks with deteriorating fundamentals may be dropped at any time.

Vanguard charges an 0.08% expense ratio of for this fund, which places it among the cheapest dividend-growth funds available. It earns a Positive Price Pillar rating.

Over the trailing three years ended March 2019, this fund lagged its benchmark by 5 basis points annually, less than its average annual fee over this period.

Bronze-rated  WisdomTree U.S. Quality Dividend Growth ETF (DGRW) (0.28% fee) is a close peer of VIG. It offers diversified exposure to highly profitable stocks with durable competitive advantages that have the capacity to grow their dividends in the future. This fund focuses on forward-looking quality metrics such as return on equity and return on assets. The fund does not consider a stock's past record of dividend hikes like VIG, and the fund's risk has been slightly higher than that of VIG.

For investors targeting dividend yield, Silver-rated  Schwab U.S. Dividend Equity ETF (SCHD) (0.06% fee) balances profitability with high yield to target profitable dividend payers. SCHD requires stocks to have paid its dividend for 10 consecutive years to be eligible for inclusion. SCHD targets 100 stocks with high dividend yields, return on equity, cash flow/debt, and five-year dividend-growth rates.

Bronze-rated  FlexShares Quality Dividend ETF (QDF) (0.37% fee) balances dividend yield with profitability metrics. QDF targets large-, mid-, and small-cap dividend-paying stocks but applies a proprietary quality scoring model to avoid stocks at risk of cutting their dividends.

 Vanguard High Dividend Yield ETF (VYM) (0.06% fee) prioritizes dividend yield over growth and carries a Silver rating. VYM sorts U.S. dividend-paying stocks by yield, targets those representing the higher yielding half, and weights them by market cap. VYM does not screen its holdings based on their profitability, so it may hold stocks with deteriorating fundamentals. VYM lands in the large-value category, while VIG falls into the large-blend category.


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Adam McCullough has a position in the following securities mentioned above: AAPL. Find out about Morningstar’s editorial policies.