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3 Funds for the Dividend Investor

Alex Bryan reveals some funds for dividend investing during volatility.

Editor’s note: Read the latest on how the coronavirus is rattling the markets and what investors can do to navigate it.

Christine Benz: Hi, I'm Christine Benz from Morningstar. The pandemic has had implications for a broad swath of businesses, and dividend-paying companies haven't been immune. Joining me to discuss the state of the dividend-paying universe, as well as to share some funds he likes, is Alex Bryan. He's editor of Morningstar ETFInvestor.
Alex, let's just do a little bit of stage-setting. Let's talk about how dividend-paying stocks have performed on a total return basis as we've come through this pandemic and its related economic effects.

Alex Bryan: Dividend-paying stocks have tended to underperform the market in the first five months of the year, so if you look at the performance of the index that Vanguard High Dividend Yield ETF (VYM) tracks, it's lost just over 13% in the first five months of the year, and that is more than most broad market indexes. A lot of that underperformance actually owes to the value tilt that a lot of dividend-paying stocks have, and value stocks in the first part of the year have underperformed the broader market, so that's a big part of where that underperformance is coming. But certainly, the capital loss has more than offset the attractive yields that a lot of those stocks offer.

Benz: Well, let's talk about the dividends themselves. There have been some dividend cuts. Let's talk about where they have tended to be concentrated.

Bryan: The cuts this year have been concentrated broadly in the more cyclical industries, so if you look at consumer cyclical energy, which isn't surprising given what's happened with oil and gas prices coming down. Industrials have had a lot of dividend cuts. Industrials actually includes airlines, like American Airlines (AAL), which suspended its dividend earlier this year. And it's also been a bit of a challenging time for real estate dividend-paying stocks, particularly because a lot of those focus on commercial real estate, which has been hit hard, or hotels, and a lot of people aren't traveling now. Even areas of the market where you think you wouldn't have a lot of cyclicality like real estate, there is actually quite a bit of cyclicality, particularly in this market environment.

Benz: Panning out to encompass the mutual funds and ETFs that focus on dividend-paying stocks, you and the team separate the dividend-paying universe into really two categories: the growers, you call them, those with dividend growth or appreciation strategies, and those that focus on higher-yielding companies. Let's start with the growers and talk about their performance pattern, and I'd also like to talk about some funds that you like in this space.

Bryan: Dividend growth strategies aren't necessarily looking for stocks that have the highest dividend yields. They're looking for stocks that have a record of dividend growth or that have potential to grow their dividends in the future, so these tend to be more quality-oriented than most income-focused strategies.

One of our favorites in this space is a fund called Vanguard Dividend Appreciation ETF (VIG), which basically screens for stocks that have raised their dividends for 10 years straight. And if you think about the types of companies that can do that, they tend to have durable competitive advantages, shareholder-friendly management teams, and really strong profitability. And dividend growth strategies like this tend to be a little bit more defensive than your more yield-oriented strategies, so they tend to hold up a little bit better than the market during downturns and they lag a little bit during market rallies. But over the long term, we'd expect these to offer more attractive risk-adjusted performance than the market. So that particular fund is rated Silver. It's one of our favorites in this space.

Benz: So that's Vanguard Dividend Appreciation. How about for people who want to include a portfolio of higher-yielding companies as a component of their portfolios? First, let's just kind of discuss the risk/reward trade-offs associated with strategies like that, and then get into a fund or two that you like in that area.

Bryan: Dividend-yielding strategies tend to have a bit of a value tilt just because if you're offering a high dividend yield, you tend to be trading at lower valuations, and a lot of these companies are paying out a large share of their earnings as dividends so they're not reinvesting in the business quite as much. Any time value stocks are out of favor, that tends to be a headwind where, these types of strategies.

But when you think about dividend-yielding strategies, there's really one of two ways you could go. You could either stick with a broadly diversified strategy that tries to spread out its risk because there are going to be some high-yielding stocks out there that aren't going to be able to sustain their dividend payments. High yields can often be an indicator that the dividend is not sustainable, so one way to stay out of trouble is to stick with a broadly diversified fund. One fund that I really like there is Vanguard High Dividend Yield ETF, which basically targets the higher-yielding half of the U.S. stock market and weights them based on market capitalization. So that way it's going to own a few bad apples, but they shouldn't have a big impact on the portfolio, given how broad it is.

The other way you could go is to focus on a strategy that screens for both dividend yield, as well as quality, or dividend sustainability, which does help filter out some of those stocks that may not be able to sustain their high dividend payments. One option that I really like there is Schwab U.S. Dividend Equity ETF (SCHD). This fund basically targets stocks that have attractive yields, strong dividend growth over the past five years, high return equity, which is a measure of profitability, and strong cash flow relative to their debt, so this is focusing on both quality as well as income. And it's tended to hold up a little bit better than broader dividend strategies during the first five months of the year, as well as during market downturns more broadly. So I think either one of those two options would be a good way of boosting your yield in a risk controlled manner.

Benz: Okay, Alex. A timely discussion, and thank you for being here to discuss what's going on with dividend-paying stocks as well as to share some things. Thanks for being here.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.

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