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Not all yield strategies are created equal

Not all yield strategies are created equal

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. 

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 £14.5bn in assets.

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 sit 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 referred to as yield chasers, tend to select constituents exclusively on the basis of high current and/or prospective payouts. 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 payouts.  

While dividend growers are more likely to generate stable income streams and grow capital over time, that does not 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 falls 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. 

The top five dividend ETFs in Europe by assets, excluding property funds and MLPs.

ETF Name

Benchmark

Fund Size (£)

Dividend Strategy

SPDR® S&P US Dividend Aristocrats

S&P High Yield Dividend Aristocrats

1,999,440,384

Growth

iShares STOXX Global Select Dividend 100 (DE)

STOXX Global Select Dividend 100

867,422,246

Growth/Income

SPDR® S&P Euro Dividend Aristocrats

S&P Euro High Yield Dividend Aristocrats

825,018,278

Growth

iShares UK Dividend

FTSE UK Dividend Plus

778,283,124

Income

iShares EURO Dividend

EURO STOXX Select Dividend 30

538,458,325

Growth/Income

Source: Morningstar Direct – data as of 18/09/2016

Under the umbrella of dividend-focused ETFs, the Dividend Aristocrats funds are amongst the largest in Europe. The popularity of these products can be attributed to their relative security of income.  

There is one main requirement for a company to be included in an Aristocrats index: it must have maintained or increased dividends for many consecutive years: 10 for the European indices and 20 for the US index. If a company misses a dividend payment or produces negative earnings growth, it will be removed. The approach is elegant and simple.

The screening criteria for other well-known dividend-focused benchmarks are less stringent. For example, FTSE dividend indices screen for the highest yielding stocks within their respective regional universes, such as the FTSE 350 for the UK and the FTSE All-World for the world. The securities are then weighted either by their 12-month forward dividend yield or by market cap, depending on the index.