It’s no surprise that dividend ETFs have gained popularity during the past few years. In the current landscape of rock-bottom interest rates, coupled with an increasing number of retiring baby boomers, many income-seeking investors have looked to dividend ETFs to compensate for the low yields bonds offer.
Simply buying the highest-yielding stocks bears considerable risk
These strategies remain the most popular segment of the smart beta ETF market. At the end of August 2016 there were 48 dividend-oriented ETFs domiciled in Europe, collectively amounting to £14.5 billion in assets.
Investors seeking equity-income opportunities often look at a fund’s current yield in isolation. But not all dividend strategies are created equal and their differences impact the risk and return profile of the overall portfolio.
Broadly speaking, dividend strategies fall along a continuum, with those that emphasise high dividend income on one end and those that prioritise dividend growth on the other. In general, the strategies reflect a trade-off between current yield and potential dividend growth.
Income-oriented strategies, also commonly referred to as yield chasers, tend to select constituents exclusively on the basis of high current and/or prospective pay-outs. They are fairly agnostic to dividend sustainability.
But simply buying the highest-yielding stocks bears considerable risk. These companies tend to pay out a dangerously high share of their earnings and may not be able to maintain their dividend payments. Stock prices typically decline ahead of, and with, these dividend cuts.
In contrast, dividend-growth strategies tend to favour firms with sustainable competitive advantages, extensive dividend growth histories and solid profitability. On the whole, they typically offer lower yields in exchange for safer pay-outs.
While dividend growers are more likely to generate stable income streams and grow capital over time, that doesn’t necessarily mean they are less risky investments than higher-yielding stocks. Companies that consistently increase dividends throughout market cycles face more demanding expectations to increase their earnings.
There is a third group of ETFs that fall somewhere in the middle of the dividend income/dividend growth spectrum, attempting to find a balance between the two. In order to limit risk, these strategies apply fundamental analysis or quantitative filters to screen out distressed firms. One caveat is that sustainability filters are often backward looking. There is no guarantee these companies will pay dividends in the future.
Generally speaking, the flagship family of S&P Dividend Aristocrats indices lean more toward dividend growth, while the FTSE Dividend indices skew more toward income. Meanwhile, the STOXX Select Dividend indices exhibit characteristics of both.
