A Growth-Focused Dividend Strategy

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, stable, and run by a shareholder-friendly management team. Vanguard International Dividend Appreciation ETF VIGI looks for these stocks listed on foreign exchanges.

VIGI steers its portfolio toward high-quality firms with strong dividend growth that should offer attractive long-term returns. This low-cost fund earns a Morningstar Analyst Rating of Bronze.

The fund tracks the Nasdaq International Dividend Achievers Select Index, which targets large- and mid-cap stocks from developed and emerging markets that have increased their dividend payments for seven consecutive years. It applies additional filters to eliminate stocks that may not be able to sustain their dividend growth. The index weights its holdings by market capitalization to help mitigate turnover and trading costs. It also limits individual stocks to 4% of the portfolio at the annual rebalance to improve diversification.

Screening for stocks with seven years of dividend growth is a strict hurdle that provides a big advantage. It indirectly targets companies that not only have the capacity to make dividend payments but also a willingness to do so. But this screen does have some downsides. It doesn’t consider 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 it is welcomed back.

Overseas 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.

This strategy has a short but promising track record. Its focus on high-quality stocks with consistent dividend growth helped it beat the MSCI ACWI ex USA Growth Index on a risk-adjusted basis from its launch in February 2016 through May 2019. Its relatively low fee is another advantage that should aid its category-relative performance.

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 the dividend payments from foreign companies are less stable than those from U.S. corporations. 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 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 Morningstar 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 market peers. These include poorly maintained infrastructure and undeveloped regulatory systems.

Portfolio Construction This fund targets companies with a strong history of raising their dividend payments, which leads to a portfolio of large stable firms that should provide solid performance. It earns a Positive Process Pillar rating.

The managers use full replication to track the Nasdaq International Dividend Achievers Select Index. This benchmark starts with all stocks in the Nasdaq Global Ex-U.S. Index, which includes companies listed in both developed and emerging markets. The process excludes REITs and firms 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. The index weights stocks that meet these criteria by market capitalization, subject to a 4% maximum weighting at the time of the rebalance. The index reconstitutes annually in March.

Fees This fund's expense ratio is one of the lowest in Morningstar's foreign large-growth category, so it earns a Positive Price Pillar rating. In November 2018, Vanguard closed the Investor share class and lowered the investment minimum on the Admiral share class to $3,000 from $10,000 ($3,000 was the minimum for the outgoing Investor share class). The Admiral shares and ETF both cost 0.25%. The Admiral shares lagged the fund's target index by 19 basis points annually from their launch in February 2016 through May 2019. Vanguard's fair value pricing strategy was a modest tailwind that allowed the fund to make up for a fraction of its expenses, but investors should not expect this advantage to persist.

Alternatives 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 a fraction 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 Fund 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. This strategy weights stocks by dividend payments and it uses forward contracts to hedge away foreign exchange risk. WisdomTree International Quality Dividend Growth Fund IQDG follows the same strategy as IHDG, but charges 0.38% and does not hedge currency risk.

iShares Edge MSCI Min Vol EAFE ETF EFAV (0.20% expense ratio) and iShares Edge MSCI Min Vol 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.

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