ETF Investing

This fund targets profitable U.S. firms with a long history of raising dividend payments.
By Adam McCullough | 07/12/17

In an article published earlier this year I highlighted several funds that paid the price for chasing high-dividend-yielding stocks. Putting too much emphasis on dividend yield can harm the total return of your equity-income investment, so it's important to focus on an investment's prospective total return -- not solely its yield -- as higher yields usually imply greater risk.

About the Author
Adam McCullough, CFA, is a manager research analyst for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. He covers passive strategies. Before joining Morningstar in 2016, McCullough worked as a growth equity analyst for FCI Advisors and served on its manager research committee. Before that, he was the lead analyst on two macro-driven, top-down exchange-traded fund strategies and a covered-call strategy for Tower Wealth Managers. Both firms are Registered Investment Advisors in Kansas City, Missouri. McCullough began his career with Ernst & Young’s financial-services office advisory practice, focusing on risk management and derivative valuation. McCullough holds a bachelor’s degree in finance and accounting from Syracuse University. He also holds the Chartered Financial Analyst® designation.

For example, high-yielding stocks could be under financial distress and thus may be more likely to cut their dividend payments than their lower-yielding counterparts. And many high-yielding stocks pay out a large share of their earnings as dividends, leaving a small buffer to cushion these payments if their business deteriorates.

 SPDR S&P Dividend ETF (SDY) effectively mitigates some of the risks associated with high-dividend-paying stocks by screening for highly profitable U.S. companies with a long track record of increasing dividend payments. This dual focus reduces the fund's exposure to firms with weak fundamentals that may not be able to sustain their dividend payments, which is a risk that often accompanies a narrow focus on yield. It earns a Morningstar Analyst Rating of Silver.

SPDR S&P Dividend ETF tracks the S&P High Yield Dividend Aristocrats Index, which includes stocks from the S&P 1500 Composite Index that have increased their dividend payment for at least 20 consecutive years. The fund's focus on firms that are financially healthy enough to grow their payouts favours profitable companies with durable competitive advantages. Moreover, its average dividend yield has measured about 30% higher than that of the Russell 1000 Value Index since the fund's inception in November 2005.

The fund's lengthy dividend-growth look-back leads to persistent sector bets compared with its category peers. For instance, during the past decade, the fund's energy sector exposure has measured a fourth of the category average, and its materials sector weighting triple the category's. And given their dividend payment stability, the fund persistently has greater exposure to the utilities and real estate sectors. Because the fund selects holdings from a broader selection universe and weights its holdings by their dividend yield, its average market capitalization is smaller than its category average. As of October 2017, its average market cap measured US$20 billion, less than half that of its category.

Despite its smaller market capitalization, the fund's tilt toward more-stable stocks has helped it shine during market downturns. It held up better than the Russell 1000 Value Index and landed in the top quartile of the large-value category during the market drawdown from October 2008 to March 2009. The fund outpaced its category by 3.2% during the trailing 10 years through October 2017, primarily because of greater exposure to utilities stocks, smaller exposure to energy stocks, and more favourable stock exposure within the financial sector.

Fundamental view

In a theoretical frictionless market, dividend payout policy shouldn't impact stock returns. A dividend payment should reduce the firm's stock price by an offsetting amount. But in practice, dividends often matter because they can impose greater discipline on managers in their capital-allocation decisions, leaving less money for low-return investments. And managers may use these payments to signal their confidence in their firms' prospects. Dividends can also help address some behavioural issues, including many investors' reluctance to realize capital gains to meet income needs, and may give them the fortitude to weather market volatility.

Investors can benefit from owning dividend-paying stocks, but chasing yield can be dangerous. The highest-yielding stocks could be under financial distress and more likely to cut their dividends than their lower-yielding counterparts. Many of these stocks pay out a large share of their earnings as dividends, leaving a small buffer to cushion these payments if their business deteriorates. This fund strives to mitigate this risk two ways. First, it selects its holdings from stocks that have increased their dividend payout for 20 consecutive years. Second, it caps individual stock weightings at 4% of its portfolio at its quarterly rebalance. If a stock is more profitable, it should be able to maintain its dividend during a market downtown or raise its payout ratio in the future.

Like most dividend-oriented strategies, this fund has a pronounced value tilt. Mature, slow-growing firms tend to trade at lower valuations and pay out a larger share of their earnings as dividends than their faster-growing counterparts, which invest aggressively to expand. Both characteristics can lead to higher dividend yields. Not surprisingly, the fund's holdings were expected to pay out a larger share (59%) of their earnings as dividends at the end of October 2017 than the Russell 1000 Value Index (46%).

The fund's 20-year dividend-growth requirement is a tough hurdle to clear. If a company doesn't continue to raise its dividend, it is out for at least 20 years. Top holdings currently include  AT&T (T),  Target (TGT), and National Retail Properties (NNN). Weighting the fund by indicated dividend yield tilts its portfolio toward smaller dividend-paying stocks. The fund caps single-stock exposure at 4% at its quarterly rebalance, and the fund's top 10 holdings occupy less than 20% of its total portfolio.

State Street charges a 0.35% management-expense ratio for this ETF. While less-expensive dividend-targeting index options are available, the fund's fee still scores in the lowest third of index mutual funds and exchange-traded funds in the category. Over the trailing three years ended October 2017, this fund lagged its benchmark by 0.4% per year, slightly higher than its average annual fee over this time frame.

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