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By Adam McCullough, CFA and Karen Wallace | 05-24-2017 02:00 PM

Our Favorite Dividend ETFs

Vanguard Dividend Appreciation, Vanguard High Dividend Yield, and Schwab Equity Dividend are all fine--but different--passive choices.

Karen Wallace: For Morningstar, I'm Karen Wallace. It's not hard to convince many investors of the virtues of dividend investing. Especially, in this low-yield environment, investors have taken renewed notice of the attractions of dividend-paying securities. Joining me to discuss some of our favorite exchange-traded funds that ply dividend strategies is Adam McCullough. He is a manager research analyst of passive strategies for Morningstar.

Adam, thanks so much for being here.

Adam McCullough: Happy to be here, Karen.

Wallace: So, Adam, dividend investing has become a popular strategy, and in fact, one of our favorite actively managed funds, Vanguard Dividend Growth, has closed to new investors in the wake of strong inflows last summer. But there are plenty of passive funds that also ply dividend strategies. What are some of the different strategies that passive funds use to target dividend payers?

McCullough: Yeah. So, on the passive side the important part is that you want to be tilted toward higher-yielding stocks but also avoid those stocks that maybe more likely than others to cut their dividend payment in the future. And so, since these are ETFs and they follow an index, they don't have the active management side to say, hey, this company is not looking as strong, maybe we should lower its weight or get it out of the portfolio. So, you have to have a process in place ahead of time to ensure, try to ensure as best you can, that those stocks won't be held in a higher weight in the portfolio.

Some of the funds that we like that do target dividends are Vanguard Dividend Appreciation, Vanguard High Dividend Yield, and Schwab Equity Dividend. And so, these three funds kind of take three separate approaches to avoiding those stocks that may be are more likely to cut their dividends in the future. So, if you think about a stock's dividend yield, it's the dividend payment divided by the price. So, what you want to do is avoid those stocks that have their yield go up because their price goes down. Because you got to cut the price in half and then the yield doubles, but that's not the right reason to look for a higher-yielding stock.

So, the first one, it's our Gold-rated fund, Vanguard Dividend Appreciation, and what this fund does is it starts with an index looking only at stocks that have raised their dividend for the past 10 years. So, already, you have a backward-looking screen, if you will, that looks for companies that have only paid their dividends. And so, the problem with that is, is that you avoid some of the larger dividend-payers like Apple, because they just started paying dividends three or four years ago, but that is a good way to avoid some of the stocks that may cut their dividends. And then this fund also applies a proprietary screening that NASDAQ implements to avoid stocks that are in lower quality or lower profitability than their peers. So, what you want is companies that are highly profitable so that they can sustain or increase their dividend payment going forward. Part of the problem with looking at higher-quality dividend funds is that the yield in this fund is closer to the category average. So, this actually lands in the large-blend category. And so, its yield is about 2.2%, 2.3%, which is in line with the Russell 1, but it is able to avoid those companies that are likely to cut their dividend in the future.

Wallace: So, higher quality companies but not necessarily the highest yield?

McCullough: Exactly.

Wallace: What if investors are looking for a fund that offers a higher yield?

McCullough: So, our second two funds that we like in the dividend targeted fund space is the Vanguard High Dividend Yield and Schwab Equity Dividend ETF. So, what these two funds do is they actually land in the large-cap value category. So, they tilt more on the value side. And that makes sense because usually higher-yielding companies may be under more financial duress and have lower growth prospects, so they fall more on the value side of the spectrum.

And so, what Vanguard High Yield does is very straightforward. It takes all the U.S. stocks that pay dividend, targets the upper half and then market-cap weights those stocks. So, while it's not looking at explicit profitability or quality metrics to screen out holdings that may cut their dividends, what it is doing is, using market-cap weightings, so it's tilting towards the largest companies and it's very broadly diversified. So, if there is a holding that does cut its dividend, it's going to be a very small impact on the fund compared to a Vanguard Dividend Appreciation, which maybe only holds 150, 180 names, Vanguard High Dividend Yield holds 400-plus names.

Wallace: So, it mitigates some of that risk by being diversified?

McCullough: Right. Exactly. And then kind of the hybrid of the two is the Schwab Dividend Equity Fund. And so, what this fund does, it hasn't had as long of a track record as the two Vanguard funds. So, you can't really see a live performance through a true bear market. But what this fund does is it takes, again, the U.S. stocks that pay dividends, targets the upper half and then scores those on an equally-weighted metric of cash flow to debt, return on equity, indicated dividend yield--so the forward dividend yield for the next 12 months--and then five-year dividend growth history. So, using this equal-weighted composite it screens out the top 100 names and then equal weights those. So, in this case, you have a market-cap-weighted fund that's screening out systematically some of the lesser-quality names that may cut their dividends which helps it to generate higher-quality dividend-paying names, but it still lands in the large-cap value category.

Wallace: We've heard a lot about so-called smart beta, strategic beta strategies in the past few years. Are there any strategic beta funds that we like in the dividend investing area?

McCullough: Yeah. So, you could probably consider the Schwab fund to be a smart beta fund because it is kind of targeting dividends and quality at the same time. But there is a fund, a WisdomTree fund that kind of tilts toward dividends in a different way. So, the first three funds were all market-cap weighted. So, that's very straightforward. They move with the prices of the stocks.

The WisdomTree LargeCap Dividend Fund actually tilts toward the aggregate dividend payment of the company. So, what that's going to do is, it's going to look at all the dividend payers in the U.S. It's going to take the top 300 by market cap. So, you still get kind of the higher market-cap tilt than you will for other more yield-focused funds. And then what this does is, it says, OK, let's take the aggregate dividend payment in dollars for a stock and then divide that by the total amount of dividends paid for all 300 stocks.

So, let's say, Apple's total dividend paid is $5 total and the total group pays $100 a year in dividends, then Apple's weight within that group will be 5%, because it's 5/100. So, even though it's not targeting necessarily the highest yielders, it's targeting those that pay the highest dividends in aggregate, which are also the largest companies. So, that kind of gives it more of a profitability-type screen where it's not going to have the small-cap stock that maybe is yielding higher amounts but can't pay that dividend going forward.

Wallace: It's an interesting strategy.

McCullough: It's a little different, yeah. It breaks the market-cap weighting kind of structure. So, then that also injects a contrarian rebalance every year. So, it rebalances once a year in December. When it does that, it's actually adjusting--so, it's cutting those stocks that have gotten more expensive compared to their dividend payment and it's adding to stocks that have gotten cheaper compared to the dividend payment. So, it actually injects a little bit more of a value tilt in that strategy compared to the other three. 

And then one more thing to note is that that strategy, Schwab Dividend Equity and Vanguard High Dividend Yield, actually pay about 20% higher on average dividends than the large-value categories. So, you are getting a little bit more oomph with those three. While the first fund I mentioned, Vanguard Dividend Appreciation, is in line with the category average.

Wallace: OK. Very helpful.

McCullough: Yeah, there's a lot going on in the dividend world.

Wallace: You've given us a lot of great ideas today, Adam.

McCullough: Happy to help.

Wallace: All right. For Morningstar, I'm Karen Wallace. Thanks for watching.

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