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This Dividend ETF Effectively Balances Yield and Quality

Its quality screen mitigates some of the risks associated with yield investing.

In an environment where trillions of dollars worth of assets sport negative yields, investors want reliable sources of income. But reaching for yield is risky business. It would be wise not to overreach.

FlexShares Quality Dividend ETF QDF targets higher-yielding stocks while anchoring on quality. Its quality orientation should help it weather downturns better than its large-value Morningstar Category peers. In combination with its cost advantage relative to its category competition, this defensive tilt should help it outperform the Russell 1000 Value Index over the long term. Under our new ratings framework, which places a greater focus on fees and benchmark-relative performance, we are upgrading the exchange-traded fund's Morningstar Analyst Rating to Silver from Bronze.

The fund fully replicates the Northern Trust Quality Dividend Index. The index is designed to provide exposure to high-quality dividend-paying U.S. stocks. It selects stocks with above-average dividend yields from its parent index, the Northern Trust 1250 Index. It further winnows the field by putting those names through a proprietary sector-relative quality scoring model that ranks stocks based on profitability, management efficiency, and cash flow. What comes out the other end is a well-diversified portfolio of high-quality, dividend-paying companies.

The firm's quality scoring model has helped the fund exit positions with deteriorating fundamentals that may be at risk of slashing their dividends. As an example, it dropped ConocoPhillips COP from its portfolio before the firm cut its dividend in early 2016.

Generally, high-yielding stocks can be risky because they usually pay out an above-average share of their earnings in the form of dividends. That leaves them with a smaller buffer to preserve dividend payments should earnings fall, making them prone to dividend cuts. However, this fund's quality screen guards against some of the risks associated with selecting stocks based on their dividend yield.

The fund's dual focus on yield and quality means it won't rank among the highest-yielding funds in the category. That said, its average annual yield since inception was 20% greater than the Russell 1000 Value Index.

Like some of its dividend-paying peers, the fund has a milder value tilt relative to the Russell 1000 Value Index and the average large-value fund, as measured by its price/book ratio. The fund's quality bent explains its relatively muted value exposure.

The fund's expense ratio is 0.37%, which is materially lower than the 0.85% average fee charged by funds in the large-value category. This gives QDF a durable edge--though its fee is significantly higher than those levied by its nearest index peers.

Process This fund targets high-quality, dividend-paying U.S. stocks, which should help it deliver and sustain an attractive yield without taking too much risk. Its profitability screen mitigates some of the risks associated with investing in higher-yielding stocks and enables it to weather downturns better than peers. This should give it an edge versus the Russell 1000 Value Index over the long haul. These considerations support an Above Average Process Pillar rating.

This fund tracks the Northern Trust Quality Dividend Index, which targets higher-yielding stocks in the Northern Trust 1250 Index. It applies a proprietary quality scoring model to mitigate the risks associated with selecting stocks based on their dividend yields. Dividend-paying stocks are typically riskier than their lower-yielding counterparts because they pay out an above-average share of their earnings in the form of dividends and have less of a buffer to cushion dividend payments if their business deteriorates.

To calculate a stock's quality score, the index combines factors such as profitability (return on equity and return on invested capital, for example), cash flow (dividend coverage ratio), and management efficiency (capital expenditures/sales). It compares each stock against its sector peers. The advantage of the fund's sector-relative quality scoring model is that unlike riskier peers, the fund avoids disproportionately loading up on a few higher-yielding sectors like utilities. Persistent sector biases are an uncompensated source of risk. Dividend-paying stocks are grouped into quintiles by score within each sector, and the lowest-scoring quintile is removed. This helps mitigate the risk of stepping into value traps. Next, the fund uses an internally developed optimizer to construct a portfolio that maximizes its overall profitability score and yield while matching the Northern Trust 1250 Index's market beta and limits stock, industry, sector, and unintended style bets.

This process is repeated four times a year, which increases turnover. However, this rebalancing frequency is intended to scale back stocks with deteriorating fundamentals that might be at risk of cutting dividends. This screen has worked to prune exposure to stocks such as ConocoPhillips in the past. That said, increased turnover also increases costs.

The fund has lagged its benchmark by an amount significantly greater than its fee since its inception. This tracking difference can be largely explained by the manner in which it has invested dividends from the stocks in its portfolio during the time between when they're received by the fund and when they are paid out to fund shareholders.

As of April 3, 2020, the fund held 128 stocks, the top 10 of which accounted for about 32% of assets. The largest holding accounted for 5.2% of the portfolio. Top holdings included steady dividend-paying companies such as Johnson & Johnson JNJ, Cisco CSCO, and AT&T T.

Like other dividend funds, the portfolio composition is different from traditional value benchmarks, like the Russell 1000 Value Index. It has been consistently underweight financial-services stocks and overweight technology stocks since inception. However, this is not surprising as its sector weights are constrained to its starting universe.

Although it has a smaller market-cap orientation than the average large-value fund, its weighted average market cap lands in large-cap territory. This slight small-cap bias speaks to the makeup of its selection universe; the Northern Trust 1250 Index consists of large- and mid-cap stocks. That said, its market-cap profile is similar to the Russell 1000 Value Index. When smaller stocks lag larger stocks, it may present this fund with a performance headwind against most of its peers.

People FlexShares equity ETFs are managed by an experienced and deep team. The group's experience and the fact that it employs a team-based approach to portfolio management somewhat alleviate our concerns related to high levels of turnover. These countervailing forces support an Average People rating.

Thirteen portfolio managers make up Northern Trust's Chicago-based U.S. equity index team, including Robert Anstine and Brendan Sullivan, who serve as the comanagers on this fund. Anstine started at Northern Trust in 2007 and began managing portfolios in 2011. Sullivan joined Northern Trust in 2012 as a senior portfolio manager. Prior to joining Northern Trust, Sullivan was an index strategist at RBC Capital Markets.

The portfolio management team utilizes a combination of third-party and internally developed tools to handle cash flows, corporate actions, and benchmark changes. It is adequately resourced, especially considering that much of the portfolio management process is automated and that the firm takes a team-based approach to running its funds. This approach mitigates the impact of historically high personnel turnover. Minimizing costs and tracking-error are the team's primary objectives, and variable compensation is tied to funds' tracking error.

Performance From its December 2012 inception through March 2020, the fund outperformed the Russell 1000 Value Index by 131 basis points on an annualized basis, while experiencing slightly lower risk. Much of this outperformance can be attributed to the fund's stock selection and overweight position in consumer cyclicals, as well as stock selection in the consumer defensive and industrials sectors.

The fund ranked in the top quartile of the large-value category over the trailing five years through March 2020, outperforming the category average while exhibiting slightly lower volatility. Since inception through March 2020, the fund also tended to hold up better than most of its category peers, as evidenced by its lower downside-capture ratio. This owes to its profitability tilt. Quality stocks tend to hold up better in downturns.

This portfolio is always fully invested, which helps its category-relative performance during bull markets but could hurt during bear markets. As of the end of March 2020, the fund had 0.67% of its portfolio sitting in cash versus 2.56% for its average large value peer.

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