What to Look for in a Dividend ETF

A version of this article previously appeared in the December 2020 issue of Morningstar ETFInvestor. Click here to download a complimentary copy.

Exchange-traded funds belonging to Morningstar's "dividend" strategic-beta group form one of the largest contingents within this universe as measured by assets under management. As of the end of November 2020, these funds collectively held $223 billion of investors' assets.

This group has been growing at a blistering pace in recent years. During the past decade, dividend ETFs have attracted $140 billion in new money.

This should come as little surprise; interest rates have been trending lower, and demand for reliable sources of investment income has surged as the first waves of baby boomers have entered retirement.

Asset managers have taken notice, and product proliferation has been the result. Of the 134 dividend ETFs that exist today, nearly three fourths are less than a decade old. Now faced with an expansive menu of dividend ETFs, it is important investors understand that these funds are not all created equal. Each has unique characteristics, which stem from important--albeit often nuanced--differences in the methodologies of their underlying indexes.

Understanding three key characteristics of these funds can help investors make more-informed choices. These include dividend yield, dividend growth, and dividend durability.

Dividend Yield A fund's current dividend yield is often the first metric investors look at when shopping for equity-income opportunities. The 12-month-yield metric aggregates an ETF's income distributions during the trailing 12 months and then divides that figure by the fund's net asset value. While this metric is interesting, it is not very useful in isolation. It needs context.

Framing a fund's 12-month yield in the background of its historical values and relative to the current and historical values for comparable strategies helps put ETFs' current yields in perspective. Exhibit 2 plots the current, average, maximum, minimum, and 75th and 25th percentiles of the monthly 12-month yields for the 11 dividend ETFs that invest in U.S. large caps and were launched prior to 2007.

It is apparent, based on a passing glance at this exhibit, that some of these funds' yields can be very volatile. And despite their similar labeling, this exhibit is a testament to just how different each fund's approach is to building a portfolio of dividend-paying stocks. For example, at the end of February 2008, the highest-yielding fund of the lot, WisdomTree U.S. High Dividend ETF DHS, had a 12-month yield of 10.32%. The lowest-yielding fund was Vanguard Dividend Appreciation ETF VIG, with a 12-month yield of 3.09%. That’s a spread of 7.23 percentage points. The market downdraft testified to the importance of understanding the particulars of the construction of these funds' underlying benchmarks. DHS loaded up on stocks whose payments proved unsustainable, including many financial-services firms. VIG rolls up stocks that have raised their dividends in 10 consecutive years, which is a sign of durability.

Those ETFs that focus on higher-yielding stocks and stocks with shorter track records of paying dividends tend to be riskier. A high dividend yield can indicate the market has soured on a firm's prospects and may be skeptical of its ability to continue to maintain its dividend at its current level. Keying on dividend yield will lend a value orientation to a portfolio and may put investors at risk of catching a falling knife (or two).

Dividend Growth Investors often look at dividend yields in isolation, without giving dividend growth its due. Dividend growth is an important component of the overall income equation, as it will determine the extent to which the expansion of an investor's equity-income stream will lag, keep pace with, or outstrip the rate of inflation. The goal, of course, is to grow this income stream at a rate that exceeds inflation, in order to grow one's real (that is, inflation-adjusted) income.

Of the 11 dividend-oriented ETFs included in the sample, three of them track a benchmark that specifically screens its investable universe for firms with long track records of paying and/or regularly increasing dividends. Isolating such companies is a backdoor quality strategy. These companies tend to be less cyclical and more profitable and have healthy balance sheets. In Morningstar parlance, they often have economic moats--durable competitive advantages--that allow them to earn juicy profits for extended periods. These firms are often well-positioned to increase dividends over time and will, on average, fare better than the market during downturns.

Dividend Durability Perhaps even more important than dividend growth is the overall stability of the dividend income stream. After all, investors looking to these funds as a source of cash flow would be disappointed to find that their income stream is volatile and may be devastated if they were to take a substantial pay cut.

The global financial crisis provided a test case for these ETFs, putting the dividends of the stocks they owned under extreme pressure. For each of the funds in this sample, I calculated what I'll refer to as their maximum dividend drawdown: the largest year-on-year decline in their annual dividend payment. Unsurprisingly, all three ETFs whose benchmarks specifically screen their constituents based on a long history of paying and growing dividends had, on average, relatively muted dividend drawdowns. Much like dividend growth, the durability of firms' dividends speaks to the quality of their franchises, the consistency of their cash flows, and thus their ability to continue to return cash to their shareholders in the form of dividends even in the trough of an economic cycle.

Putting It All Together Exhibit 4 puts it all together. The exhibit features 12-month yields, the maximum year-on-year drawdown of the annual dividend, the trailing five- and 10-year compounded annualized growth of annual dividends, and expense ratios for the 11 ETFs featured above. The composite score in the far right column is a simple sum with a maximum value of 5. If an ETF has an above-average current yield, a below-average maximum dividend drawdown, above-average dividend growth during the trailing five- and/or 10-year periods, or a below-average fee, it earns a point. I ranked the ETFs in this group by their composite scores.

This ranking is a back-of-the-envelope assessment. It is not meant to be a comprehensive list of best-of-breed funds, especially as it excludes many newer entrants that also dabble in U.S. large caps, like Schwab U.S. Dividend Equity ETF SCHD and FlexShares Quality Dividend ETF QDF (both carry Morningstar Analyst Ratings of Silver). That said, it provides a useful guide for conducting your own due diligence on dividend ETFs. Investors scrutinizing these ETFs should consider the following:

1) Price Fees are the most stable, explicit, and predictable detractor from future performance and will come directly off the top of an investor's income stream. Look for low-cost funds.

2) Yield Do not consider yield in isolation. Rather consider it in its historical context, how it stacks up relative to peers, and how it ties back to the underlying index methodology. Higher-yielding funds tend to court more risk.

3) Growth Look for funds that can grow their dividends at an inflation-plus rate over the long haul. Benchmarks that specifically screen for dividend durability and/or prospective growth should have better odds of growing their income streams over time and tend to invest in higher-quality firms that enjoy economic moats.

4) Durability Investors should place a premium on dividend durability, particularly in bear markets. On average, the ETFs in the sample I studied that specifically screen for growing and/or stable dividends fared better during the global financial crisis, experiencing relatively muted dividend drawdowns versus their peers. Silver-rated VIG fits this mold.

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