With the rising number of retirees as well as uncertainty in the financial markets, there’s been plenty of good reason for dividend investing to come into vogue in recent years. With that increased attention, fund providers have come out with a plethora of mutual funds and ETFs that offer dividend exposure. Selecting the right fund can be confusing — but a systematic decision approach can help.
In a recent blog post, Holly Framsted, CFA and head of US Factor ETFs at BlackRock’s ETF and Index Investment Group, described a dividend-fund selection framework that includes what she called 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,” she said.
Among the different strategies in the market, dividend yield and dividend growth are particularly popular. Dividend yield factor strategies seek companies that pay above-average dividends relative to price, while dividend-growth mandates look for companies that consistently raise dividends.
“Following the Global Financial Crisis many dividend-oriented funds employ quality screens as part of their investment process,” Framsted explained. “These screens help to ensure companies within the portfolio are less susceptible to the proverbial ‘yield trap.’”
Sector considerations come in when one considers common wisdom in dividend investing: high-dividend-paying companies tend to be concentrated in more mature industries. According to Framsted, high barriers to entry, being more established, and having less concern for reinvesting to achieve rapid growth all allow such companies to set aside more of their earnings to reward investors. Dividend growth, meanwhile, is more a hallmark of companies in financials as well as growth-oriented sectors like information technology and consumer discretionary. It’s a more feasible approach for companies with modest dividends that are experiencing increased amounts of cash flow.
Turning to style, Framsted discussed how the Morningstar Dividend Yield Focus Index tilts heavily into the Morningstar value category with minimal growth exposure, whereas the Morningstar US Dividend Growth Index is 13% weighted toward growth.
“For many investors, it may be a surprise to see meaningful growth exposure in a dividend strategy,” she said, noting that dividend payments are typically given at the expense of reinvestment into a business’s 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, Framsted continued, has typically been a feature of dividend strategies. Aside from dividend-paying companies’ tendency to carry more debt, they’re often offered as an alternative to income from debt securities. Rising interest rates, therefore, can hurt dividend payers by increasing their debt burden and shifting investors’ income appetite in favour of bonds.
“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,” Framsted said.
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