Dividend exchange-traded funds (ETFs) are a popular category with investors, particularly during difficult markets like the one experienced in 2022. This helps to explain why the category collected $69.5 billion in new assets last year, gathering nearly 12% of all flows into U.S.-listed ETFs. Companies that can pay dividends throughout the market cycle tend to be of higher quality, offering investors a degree of stability that helps explain their draw during times of volatility.
Most dividend ETFs, including some of the largest in the category, are passive, meaning they rely on a rules-based index methodology for portfolio construction. Although the exact methodology can differ between indexes, passive ETFs generally select the highest-yielding securities within the investment universe for inclusion within the portfolio. In our view, looking beyond the yield generated by each individual name and taking a more diversified active approach to selecting a portfolio of dividend-paying stocks can offer some advantages over these passively managed, single-factor ETFs.
Why do dividends matter?
Dividend stocks provide two separate sources of return: income from dividend payments as well as any price appreciation. Although investors usually think of fluctuations in a security’s price when they consider the potential return of an investment, dividends can be a significant driver of total return. Looking at the U.S. market from 1927 through 2022, dividends account for approximately 38% of total return.
Dividend yields have come down over time but undeniably remain an important component of total return while also providing a level of stability for investors. Depending on the phase of the market cycle, price return can fluctuate from positive to negative year to year; in contrast, dividends are always a positive source of return. This helps to explain why dividend-paying names tend to experience less volatility on average compared with stocks that don’t pay a dividend.
Although dividend payments provide a signal of quality to investors, price return remains the primary driver of total return and should be taken into consideration when selecting investments to construct a dividend portfolio. In other words, dividend stocks should be selected not just based on their individual dividend yield levels, but with the potential for capital appreciation in mind while also looking to mitigate relevant potential risks.
To do this, we find it beneficial to also consider factors such as valuation, momentum, and quality. By considering such metrics in tandem with dividend yield and dividend growth, we believe the process will generate a portfolio that not only offers a sustainable stream of income but also has the potential for price appreciation. This process, along with a focus on mitigating outsize risks, can potentially help provide an even greater level of stability and growth for investors’ portfolios through a market cycle.
What can a high dividend yield tell us?
While dividend strategies often target a yield that’s above that of the market, a high dividend yield can also serve as a signal of underlying risk. This becomes clear when we consider how a company’s dividend yield is calculated.
Dividend yield is typically calculated in one of two ways: backward looking or forward looking. The backward-looking, or trailing, method takes the most recent dividends per share payments in the trailing 12-month window of time and adds them together to find an annual dividend per share. Alternately, the forward-looking, or indicated, methodology takes the most recent single dividend per share payment and multiplies it by the number of dividend payments in a typical year to derive an expected annual dividend per share number.
In both cases, the results are divided by the current share price to arrive at either a trailing or indicated dividend yield. While paying out higher dividends per share can drive up a dividend yield, so can a falling stock price.
Looking beyond yield can help to avoid a dividend value trap, a situation where a stock has an elevated dividend yield due to a declining stock price. Metrics such as profitability and momentum can help a strategy identify and avoid these value traps.
Payout ratio is another measure that can provide useful information on the sustainability of a company’s dividend. This ratio is calculated by looking at dividends per share divided by earnings per share. A high payout ratio can indicate that a company isn’t reinvesting enough of its earnings into its operations and might have to cut dividends in the future. Although we believe that this data point can provide important insight during the investment selection process, it must be considered in context with other measures of a company’s quality or profitability.
Sector concentration can be a risk
A common issue for many rules-based ETFs that track a subset of the market, including dividend ETFs, is that sector allocations might vary widely from those of the broad market. Many dividend indexes tend to favor sectors such as consumer staples and energy and may underrepresent sectors such as information technology.
This sector concentration can sometimes work in the fund’s favor, like when many dividend ETFs performed well in 2022 due to their outsize allocation toward energy stocks; however, this can be a risk if that area of the market lags, becoming a drag on the portfolio’s overall return.
Although some areas of the market such as information technology generally have lower dividend yields, companies within these sectors often have higher growth rates and, in turn, a higher potential for capital appreciation. By being mindful of sector concentrations and open to potentially including lower-yielding securities within a portfolio, an investment process can maintain a focus on total return while still reaching a fund-level yield target.
Targeting yield at the portfolio level
High dividend ETFs available in the marketplace traditionally achieve their dividend yield objective by investing exclusively in stocks with the highest dividends. As we’ve explained, such an approach can result in concentration in certain sectors or other unintended bets. We believe that by looking at dividend yield on the portfolio level and considering factors such as valuation, momentum, and quality, investors can benefit from companies that have stronger fundamentals and more sustainable dividends. In our view, this broader perspective can be a smarter approach to building a dividend ETF portfolio, resulting in a fund that can potentially deliver better outcomes for income-sensitive investors across the market cycle.
The views presented are those of the author(s) and are subject to change. There is no guarantee that any investment strategy illustrated will be successful or achieve any particular level of results. This is for informational purposes only and is not intended to be, nor shall it be interpreted or construed as, a recommendation or providing advice, impartial or otherwise, regarding any security, mutual fund, ETF, sector, or index. Investors should consult with their financial professional before making any investment decisions. Past performance does not guarantee future results.
Diversification does not guarantee a profit or eliminate the risk of a loss.
The MSCI USA Index tracks the performance of large- and mid-cap stocks of the U.S market. The MSCI USA High Dividend Yield Index tracks the performance of equities with higher dividend income and quality characteristics that are both sustainable and persistent. It is not possible to invest directly in an index.