How to Choose the Right Dividend ETF

There is a diverse array of equity-income strategic beta ETFs. Morningstar analysts explain the key differences between these dividend-weighted strategies

Kenneth Lamont 5 May, 2015 | 12:51AM
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Exchange-traded funds that are labelled ‘dividend-screened/weighted’ represent the largest contingent of the European universe as measured by assets under management. As of the end of Q1 2015, these strategic beta ETFs collectively held €17 billion of investors' assets. This represents 55% of the €30 billion in the broader strategic-beta grouping.

This category has been growing at a gathering pace over recent years. Over the trailing five-year period, dividend-oriented ETFs have attracted over €8billion in net new money.

This should come as little surprise in the context of the prevailing low-rate environment where investment income is so hard to come by.

Asset managers have taken notice, and product proliferation is in full swing. Of the 46 European dividend-screened/weighted ETFs that exist today, more than half are less than five years old. As the menu of dividend-oriented ETFs expands, it is important that investors understand that not all dividend ETPs are created equal.

Each has its own unique characteristics, which stem from important – albeit often nuanced – differences in the methodologies of their underlying benchmarks. Understanding three key characteristics of these funds, which all spring forth from differences in their benchmarks' construction, can help investors to make more informed choices.

These three characteristics are: dividend yield, dividend growth, and dividend sustainability.

Dividend Yield

A fund's current dividend yield is often the first metric that investors seek out when shopping for equity-income opportunities. The 12-month-yield metric aggregates an ETP's distributions over the trailing 12-month period and then divides that figure by the fund's net asset value. While this metric is interesting, it is not very useful in isolation. This is because it lacks context.

Framing a fund's 12-month yield in the context of its historical values and relative to the current and historical values for comparable strategies provides useful context. For example, below you can see plotted the monthly 12-month yields for those dividend exchange-traded funds that invest in Eurozone large caps and whose inception was prior to 2010.

German domiciled ETFs have not been included as the dividends on these funds are subject to different tax considerations and therefore not directly comparable. The non-dividend screened iShares EURO STOXX 50 Distributing ETF (EUEA) have been included as a point of reference.

It is readily apparent, based on a passing glance at the chart below that these funds' yields can vary significantly over time. It's also obvious that these funds' yields can diverge from one another in dramatic fashion.

Indeed, from mid-2010 until early 2011 the iShares Euro Dividend ETF (IDVY) returned a lower monthly 12-month dividend yield than the iShares Euro Stoxx 50 distributing fund (EUEA). Despite this anomaly, we can see that all three strategic beta funds shown have returned a consistently higher dividend yield through time than the vanilla iShares Euro Stoxx 50 ETF (EUEA).

At the peak of the Eurozone debt crisis in July 2012, the highest-yielding fund of the lot, the Amundi ETF MSCI EMU High Dividend ETF (CD8) had a 12-month yield of 9.02%, while the lowest yielder was db x-trackers Euro Stoxx Select Dividend 30 ETF (DXSA), with a 12-month yield of 5.03% – a spread of 3.99 percentage points.

The differing fund performance over this period of market turbulence serves to highlight the importance of understanding the nuances in the construction of these similarly labelled funds' underlying benchmarks.

Some ETPs are clearly taking on more risk than others when they go about building an income-oriented portfolio.

Dividend Growth

Investors too often look at dividend yields in isolation, without giving dividend growth its due. Dividend growth is a vital component of the overall income equation, as it will determine the extent to which 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.

Although the four ETFs included in the table above track a benchmark that specifically screens its investable universe for firms with long track records of paying and/or regularly increasing dividends, there is a significant variation in how this is achieved.

For example, the SPDR® S&P Euro Dividend Aristocrats ETF (SPYW) screens for stocks which have increased or maintained stable dividends for at least ten consecutive years. Whereas the db X-trackers Euro Stoxx Select Dividend 30 ETF (DXSA) only includes stocks that have shown non-negative dividend growth rate over the past five years and paid dividends in four out of those five years.

In an attempt to ensure future dividend streams remain strong, the Amundi ETF MSCI EMU High Dividend ETF (CD8) goes further and screens securities on additional ‘quality’ factors such as return on equity, earnings variability, debt to equity, and on recent 12-month price performance.

Dividend Stability

Perhaps even more important than dividend growth is the overall stability of a dividend-oriented ETP's 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.

One measure we can look at to measure dividend stability is the "maximum dividend drawdown." That is, the largest negative year-on-year decline in a funds’ annual dividend payment.

When we attempt to calculate this for the dividend screened funds above, we are somewhat hamstrung by the lack of historical data. Only the db X-trackers Euro Stoxx Select Dividend 30 ETF (DXSA) and the iShares EURO Dividend ETF (IDVY) have a long enough history to allow us to observe the impact of the Eurozone debt crisis in 2009 on dividend payments.

These funds reduced dividend payments by 58.6% and 53.1% respectively between 2008 and 2009, which was significantly more than the 25.44% calculated for the non-dividend screened iShares Euro Stoxx 50 Distributing ETF (EUEA) over the same period. This indicates that although these funds have produced a superior dividend stream through time, they may be vulnerable to dramatic falls in payments over periods of market stress.

Putting It All Together

As demonstrated above, the performance of different dividend ETPs can vary dramatically through time and investors should look beyond TER when conducting due diligence. When assessing each fund, the following aspects should be considered:

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 But do not consider yield in isolation. Rather consider it in its historical context, how its stacks up relative to peers, and how it springs forth from the underlying index methodology.

3) Growth Look for funds that can grow their dividends at an inflation-plus rate over the long haul. Benchmarks that specifically screen on the basis of historical and/or prospective growth should have better odds of growing their income streams over time.

4) Stability Investors should place a premium on income stability, particularly in bear markets.

This article has been adapted from an article published on Morningstar.com by Morningstar Passive Fund Analyst Ben Johnson to make it suitable for a UK audience

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Kenneth Lamont  is a passive funds research analyst for Morningstar Europe.