A version of this article previously appeared in the November 2019 issue of Morningstar ETFInvestor. Download a copy here.
Dividend-income funds can look appealing to those seeking a stable source of income. Done well, they can deliver on this objective. But there is some nuance to determining what constitutes a good dividend-income index strategy.
Index-tracking dividend-income funds fall under the strategic-beta framework within our enhanced ratings methodology. The Morningstar Analyst Ratings assigned to these funds reflect our level of confidence in their ability to outperform their Morningstar Category indexes on a risk-adjusted basis. But many investors looking for dividend income are more concerned with the income provided by these strategies and less so with their ability to beat a bogy. Furthermore, a fund's potential to beat its category benchmark may not necessarily align with its ability to provide consistent dividend payments.
That said, the Analyst Rating is still a great place to start when evaluating dividend-income funds because these funds' ratings are primarily driven by their Process Pillar ratings and the fees they levy. Above Average Process ratings lead to Morningstar Medalist status and not only reflect our confidence in a fund's ability to beat its category index, but also incorporate our judgment regarding how well it can deliver on its objective while mitigating the risks that it may encounter.
Dividend-income funds often have a value orientation and therefore are more exposed to certain risks than the broader market. I'll touch on these specific risks and break down two dividend strategies to show the differences between the good and the not-so-good.
The Genesis of High Yields
Broadly speaking, there are two ways that a stock's yield can increase. A company can increase its dividend payment relative to the price of its shares, or the stock's price can decline relative to its dividend payment.
Changes in dividend payments don't occur in a vacuum. Stocks with rising dividends are often backed by financially stable companies with strong sales and profit growth that support those higher cash distributions. These profitable companies often trade at higher prices relative to their fundamentals, including dividends, and rarely if ever land in the higher-yielding segment of the market.
Dividend-payers with falling prices are more likely to find their way into high-yield portfolios. But it's important to realize that share prices often fall for a reason--typically when a company's outlook becomes less rosy. Poor prospects and depressed prices are what cause dividend-income funds to move further to the value side of the Morningstar Style Box and translate into two big sources of risk. First, the prices of high-yielding companies may fall further in the short run. Second, companies with poor prospects may cut their dividends to preserve cash.
General Electric's GE recent performance exemplifies these risks. Its share price began declining in early 2017 as the company's profits began slowing. Executives responded by halving the firm's dividend in December of that year (to $0.48 per share from $0.96 per share annually). But its share price continued falling in 2018, which pushed its yield higher. While its dividend-yield looked attractive, management ultimately slashed the annual dividend to $0.04 per share in December 2018.
Not every high-yield stock suffers the same misfortune as GE. While these risks cannot be completely avoided, well-constructed dividend-income funds take steps to control their exposure to these perils and occupy a reasonable middle ground between yield and limiting risk.
Under the Hood of a Good Strategy
Gold-rated Vanguard High Dividend Yield ETF VYM is an example of a dividend-income fund that strikes a sensible balance. It ranks among the highest-rated dividend-income funds in the large-value category, underscoring our confidence in its process.
VYM tracks the FTSE High Dividend Yield Index. This well-diversified benchmark starts with all dividend-paying stocks in the FTSE All-World Index. It focuses on those listed in the United States and excludes REITs. By law, REITs must pay out 90% of their earnings as dividends, so they tend to have a higher yield than the U.S. market. Including them could cause the final portfolio to be overweight in this sector and compromise its diversification.
From these dividend payers, the index strips out those not expected to pay a regular dividend over the next 12 months. This is by no means a thorough way to avoid companies that may cut their dividends, but it does prevent the dodgiest names from making their way into the portfolio.
The index then sorts the remaining dividend payers by their expected yield using forecast dividend payments from I/B/E/S. It adds names to the portfolio, starting with those having the highest expected yield and continuing until it captures 50% of the dividend payers' total market capitalization. This sweeps a large number of stocks into the portfolio and improves the fund's diversification potential. Historically, it has held between 400 and 600 names, while its 10 largest holdings have represented less than one third of its assets.
After screening and selecting stocks, the index weights its final constituents by their market cap. This approach has two benefits. It mitigates turnover and the related trading costs, as each stock's weight will adjust proportionally to changes in its price. Market-cap weighting emphasizes larger companies that are likely more stable and profitable than those with smaller market caps. In the context of dividend-paying stocks, these relatively larger firms have better odds of continuing to make their dividend payments.
Diversification is an important characteristic that investors should home in on when looking for good dividend-income fund. Most dividend-income strategies will hold some bad apples. A broad basket of high-yielding stocks reduces the potential for them to significantly hurt a fund's performance.
Vanguard also offers an international version of this strategy: Gold-rated Vanguard International High Dividend Yield ETF VYMI. It employs nearly the same process as VYM but focuses on stocks listed in foreign developed and emerging markets.
Dividend-income funds that aggressively target high-yielding names are prone to overweight those with looming dividend cuts, further price declines, or both. Thus, they deserve a high level of scrutiny.
Negative-rated SPDR S&P International Dividend ETF DWX is one such strategy. It holds the 100 highest-yielding stocks listed in foreign markets and weights them by their trailing 12-month yield. Despite holding fewer names than VYMI, it still reasonably diversifies stock-specific risk by capping the weight of each stock at 3% of the portfolio.
Weighting by dividend yield is the fund's real weak point. This technique tilts the portfolio toward the highest-yielding names and can push its yield higher than VYMI. But weighting stocks in this fashion simultaneously emphasizes companies that are the most at risk of future dividend cuts. This approach also ignores each stock's price. Consequently, DWX will increase its exposure to stocks that have declined in price relative to yield, causing it to overweight those with negative momentum (stocks that have declined in price and are likely to continue doing so).
This scenario played out in early 2015, when many energy stocks suffered following a collapse in the price of oil. DWX piled into many of these names as their yields increased, overweighting the energy sector by 10% relative to the MSCI All Country World Index ex USA Value. But the price of these stocks continued to fall, causing the fund to underperform the benchmark by 6.5 percentage points for the year.
Simple Rules to Improve Your Odds
Digging into dividend-income strategies may not always be as straightforward as the cases above. In some instances, strategies may take measures to control risk that look great on paper but don't live up to their billing. DWX, as an example, applies profitability and dividend growth standards to its potential holdings that are weak and don't do much to ensure future dividend payments. Ultimately, dividend-income funds make a trade-off between yield and dividend sustainability. Most of the time, sustainability declines as yield rises.
A good rule of thumb to use when evaluating the investment merit of dividend-income strategies is to treat the Vanguard funds as benchmarks. Strategies that offer higher yields than VYM or VYMI (focusing on U.S. and foreign stocks, respectively) likely have greater exposure to stocks that may cut their dividends or deliver weak price performance. Furthermore, they may not diversify against stock-specific risk as well as the Vanguard funds.
Expense ratios are another important trait to focus on as they are the surest ways to improve future performance. Exhibit 1 lists some of our top-rated dividend-income funds that take effective steps to diversify their holdings and control risk while charging low fees.