Dividend Funds Got You Down?

By Holly Framsted

Overwhelmed by the sheer number of dividends funds? In Part Two of her dividend series, Holly offers an easy way to unpack which fund to use.

For good reason, dividend investing not only has become increasingly popular in recent years, but also has become more efficient through the use of ETFs. With over 300 equity income-oriented mutual funds and ETFs^[1] available, identifying and investing in an appropriate dividend fund can be difficult and confusing for even the most sophisticated investor. However, the large number of funds should not serve as a deterrent to investment. Rather, I would argue that having a clear and consistent framework in which to analyze the various funds is instrumental in understanding the differences among funds. You may consider what I call the “three S’s”: Sector, Style and Sensitivity to rates. Using this framework, we find that strategies have different characteristics and therefore can fill different, but equally important roles in a portfolio.

Two particularly popular dividend strategies are high dividend yield and dividend growth. High dividend yield seeks to provide exposure to above average dividend-paying companies relative to price, while dividend growth aims to invest in companies that consistently grow their dividends. Following the Global Financial Crisis many dividend-oriented funds employ quality screens as part of their investment process. These screens help to ensure companies within the portfolio are less susceptible to the proverbial “yield trap”. For high yield strategies such as the iShares Core High Dividend ETF (NYSEARCA:HDV), which seeks to track the Morningstar Dividend Yield Focus Index, quality screens exclude companies with less defensible business models. For dividend growth strategies such as the iShares Core Dividend Growth ETF (NYSEARCA:DGRO), which seeks to track the Morningstar US Dividend Growth Index, quality screens serve to identify companies that have consistently grown their dividends over time. While both strategies provide access to high-quality, dividend-oriented companies, their differing investment objectives and quality screens lead to different exposures.

Sector

Common wisdom has been that high-dividend-paying companies tend to be focused on more mature industries. Companies within sectors such as Consumer Staples and Utilities, for example, can afford to pay more of their earnings out in the form of dividends; they are generally more established, have high barriers to entry, and are less focused on reinvesting for rapid growth. As for companies that grow their dividends, the graph below shows they are concentrated within Financials as well as more growth-oriented sectors like Information Technology and Consumer Discretionary. Information technology, for example, contains companies which may have recently begun paying dividends with large amounts of cash flow at their disposal, allowing for consistent dividend growth. These sector differences lend the strategies to offer different risk and return profiles.

Style

Below we can see how the Morningstar Dividend Yield Focus Index tilts heavily into the Morningstar value category with very little exposure to growth. The Morningstar US Dividend Growth Index, however, posts 13% weight to growth. For many investors, it may be a surprise to see meaningful growth exposure in a dividend strategy. After all, companies are returning their cash flow to shareholders through the payment of a dividend rather than reinvesting that cash flow for growth. However, when we remind ourselves that firms are growing in order to sustainably increase their dividends year-over-year, the result is less surprising. This dividend growth orientation allows investors unique and diversified access to a market segment typically associated with a strong value bias.

Sensitivity to rates

Higher rates have historically put pressure on dividend strategies. Dividend-paying companies tend to carry more debt, which grows more expensive as rates rise; at the same time, bond yields become more attractive as interest rates rise, lowering the demand for income through dividend-paying stocks. That said, while high-yield dividend exposure has tended to under-perform during periods of rising rates and outperformed during falling rates, we find dividend growth strategies tend to be less rate sensitive.

Below we show the most recent rising rate period in which the U.S Treasury 10- year yield went from 1.47% to 3.14%. As rates rose, the Morningstar Dividend Yield Focus Index lagged. The Morningstar US Dividend Growth Index, however, slightly outperformed the S&P 500. Addressing rate sensitivity via a dividend growth strategy may allow investors to seek income in a more diversified way across interest rate regimes.

Conclusion

Both high-dividend and dividend-growth strategies aim to help investors generate income and add to portfolio resiliency. However, there are significant differences in the types of companies they invest in, and thus their investment profiles. High yield strategies match traditional thoughts on dividend exposure: more defensively positioned, value oriented, higher absolute income and higher sensitivity to rates. Dividend growth strategies break that mold with growth-oriented exposures and less sensitivity to interest rates. The distinctions between these strategies mean they can be used separately or together, to provide a comprehensive and diversified income solution.

This post originally appeared on the BlackRock Blog.

Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.