Exchange-traded funds (ETFs) that invest in companies with a long history of growing dividends have been popular as investors in search of income have had to look beyond bond markets due to prevailing low interest rates. However, these dividend-growing ETFs may simply push investors into companies that score higher on the quality factor, a key characteristic that can drive stock performance.
Dividend ETFs come in many flavors, but a common approach is to focus on “dividend growth” stocks that have a track record of steady dividend increases, or those that are projected to do so in the future.
Dividend growth strategies may provide some extra yield, but from a factor investor’s perspective, we think they may provide more exposure to the quality factor (also sometimes called the profitability factor). In other words, dividend growth approaches may just be another way—and possibly not the best way—to measure quality.
For one thing, focusing on a single characteristic—dividend growth—may lead to portfolio quirks and sector overweights and underweights that investors should be aware of. For example, because of the quality tilt, dividend growth strategies may be better used as a defensive complement to core equity holdings, rather than a standalone core position.
How dividend growth indexes work
The dividend growth benchmarks for U.S. stocks with the highest amount of assets following them include the NASDAQ US Dividend Achievers Select Index and the S&P High Yield Dividend Aristocrats Index.
Like all indexes, the dividend growth benchmarks can perform differently based on how they identify the stocks. Some require a component company to show 10 years of dividend increases, while other may set the bar as high as 20 years. As mentioned, some incorporate forward-looking dividend estimates rather than only historical dividends. Some weight their constituents by market capitalization, while others weight by dividend yield.
But generally, the most popular dividend growth indexes tend to contain large-cap, established companies with strong profitability that may hold up better in down markets.
Sector tilts and diversification
Dividend growth indexes may take on sector tilts relative to the S&P 500 Index, while dividend-paying stocks generally tend to be sensitive to interest rates.
In terms of sector tilts, some dividend growth indexes skew toward defensive sectors that tend to be less sensitive to economic cycles, such as utilities and consumer staples. Also, dividend growth indexes that require more years of consecutive dividend increases (20 years, for example) tend to hold fewer tech stocks. Conversely, dividend growth indexes requiring fewer years of dividend increases, and those that use forward-looking estimates, may hold more tech stocks.
Focusing on only dividend-paying stocks naturally cuts down on the selection universe. Requiring at least 10 years of dividend increases means some large-cap technology and consumer discretionary are ineligible. And once a company cuts its dividend, it’s kicked out of the index and cannot not return for at least 10 years.
Another potential key distinction among benchmarks is whether they hold real estate investment trusts (REITs), which tend to be sensitive to interest rates.
Focused on a single factor
Our view is that dividend growth strategies may make sense for investors who are looking for a bit more yield than traditional indexes, yet who also want a tilt to quality, high-profitability companies. We think dividend-growth companies can be used to play defense in a portfolio because they may fall less than the overall market when stocks decline.
However, we believe investors should be cautious about using dividend growth strategies as standalone, core holdings due to their sector concentrations and tendencies to have a single factor focus. Instead, dividend growth strategies may be better used by investors searching for yield as a complementary allocation to more broadly diversified core holdings that provide exposure to multiple return factors.