It's easy to understand the allure of dividend-paying stocks. Dividend payments can help investors manage behavioural issues such as their reluctance to realize capital gains to meet income needs, and may give them the fortitude to weather market volatility.
But focusing narrowly on dividend yield can increase risk. For example, the highest-yielding stocks could be under financial distress and thus may be more likely to cut their dividend payments than their lower-yielding counterparts. Many high-yielding stocks pay out a large share of their earnings as dividends, leaving a small buffer to cushion these payments if their business deteriorates.
A high dividend yield looks attractive at first blush, but it's also important to remember that dividend yield is a ratio: the dividend payment (numerator) divided by the stock price (denominator). A company's dividend yield increases when the dividend payment (numerator) is unchanged, but its stock price (denominator) decreases.
Be wary of backward-looking metrics
PowerShares High Yield Equity Dividend Achievers ETF (PEY) targets high-yielding stocks and seeks to reduce its risk by selecting its holdings from U.S. stocks that have raised their dividend for at least 10 consecutive years. From this subset, it selects the 50 highest-yielding stocks and weights them by their trailing 12-month yield. The fund's dividend yield figure has averaged 5.3% over the decade through May 2017, versus 2.3% for the Russell 1000 Index. Although PEY has sported an attractive dividend yield, its total return hasn't kept up with the Russell 1000 Index since its inception in January 2005.
- source: Morningstar Direct; analyst's calculations. Month-end returns from January 2005 through May 2017.
By relying on a backward-looking dividend sustainability metric and weighting its holdings by their yield, PEY has loaded up on some of the highest-yielding and riskiest stocks at the wrong time. For example, in the run-up to the financial crisis, bank stocks had amassed track records of increasing their dividend payments, so they passed PEY's dividend sustainability screen. At the end of January 2008, PEY's financial sector weighting measured 81% compared with the Russell 1000 Index's 19% weighting. And by yield-weighting its holdings, PEY allocated the greatest proportion of its portfolio to the most distressed companies. Thus, PEY suffered during the financial crisis. The fund cumulatively lost 71.4% from October 2007 through March 2009, compared with the Russell 1000 Index's drawdown of 55.1%. PEY subsequently modified its methodology to cap sector weights at 25% in November 2013, but like its backward-looking dividend screen, hindsight is 20/20. Owing to these deficiencies in its index's methodology, PEY carries a Morningstar Analyst Rating of Neutral.
There will be blood
The recent malaise in the energy sector helps illustrate the perils of loading up on high-yielding stocks for the wrong reasons. Unlike the financial crisis, the negative effects of the decline in energy prices have not spilled over into other equity sectors. The graph below shows the indicated dividend yield of both Energy Select Sector SPDR (XLE) and SPDR S&P 500 (SPY) during the past decade through May 2017. XLE represents large-cap energy sector stocks that are members of the S&P 500.
- source: Morningstar Direct.
SPY's indicated dividend yield topped XLE's for much of the past decade. In October 2014, the price of oil plummeted and XLE's indicated yield eclipsed SPY's. XLE's dividend yield didn't track higher because its dividend increased at a faster clip than SPY's, but rather because of stock price declines across XLE's holdings. XLE's indicated dividend yield topping SPY's coincided with the spot price of WTI crude oil falling to US$80.53 per barrel in October 2014 from US$107.95 per barrel in June 2014. XLE traded at a high of US$101.26 in June 2014. By the end of October 2014 it was trading at US$85.69.
Because the price of oil affects most energy companies' revenues, XLE's price fell by 15% during those months as the spot price of WTI crude tumbled by 25%. This offers an example of a fund's dividend yield increasing as a result of falling prices rather than dividend payments increasing at a rate that outstrips share price appreciation. XLE's indicated dividend yield peaked in February 2016 at 4.3% as the spot price of WTI crude bottomed out at US$26.19 per barrel. The same month, ConocoPhillips (COP), a top 10 holding in XLE, slashed its quarterly dividend payment from US$0.74 to US$0.25 per share.
Whipsawed
Global X SuperDividend US ETF (DIV) experienced the largest drawdown of the dividend-focused funds during the energy sector decline from June 2014 through January 2016. This fund cumulatively lost 17.6% during those 19 months. By comparison, the Russell 1000 Index only drew down 3.5%. This fund's average indicated yield since its inception in March 2013 has measured 7.4%. That compares to 2.2% for the Russell 1000 Index over the same time frame. So where did DIV go wrong?
DIV tracks an equally weighted 50-stock index that targets stocks with high dividend yields and low betas compared with the S&P 500. This fund starts with stocks that have betas of 0.85 or less, have paid dividends for at least two years, and whose current dividend payments are at least 50% higher than the prior year's payment. Next, it ranks the stocks in descending order by dividend yield, selects the top 50, and equally weights them. The fund limits sector weights to 25% of the portfolio. It reconstitutes annually and rebalances quarterly. Even with sector caps in place, this fund loads up on utilities, energy, consumer defensive and real estate stocks. Because it equal weights its 50 holdings, it skews toward smaller stocks, with an average market capitalization of US$6 billion.
Although the fund looks for stocks that had increased their dividend yield, it doesn't consider dividend sustainability. Since DIV's March 2013 inception, its payout ratio, or the ratio of aggregate dividends paid relative to its holdings' net income, has measured greater than 1.0 times nearly every month. A company that pays out a dividend greater than its reported earnings is at risk of cutting its payout. Such firms may be borrowing to meet their payment and could be neglecting reinvestment needs. So, while DIV's average dividend yield of 7.4% looks attractive on the surface, the outlays of many of its holdings don't seem sustainable considering the funds' payout ratio is greater than 1.
Focus on total returns
Investors can avoid stepping on land mines in the field of dividend-oriented ETFs by understanding how these funds target and weight dividend-paying stocks, and seek to reduce the risks of holding high-yielding companies. Most dividend-targeting funds use several approaches to reduce risk such as:
1. Screening for profitability. If a stock is more profitable, it should be able to maintain its dividend during a market drawdown or increase its dividend in the future. These metrics usually include return on invested capital, net margin, payout ratio, interest coverage and cash flow-related measures.
2. Looking for a history of dividend payments. Many equity-income benchmarks screen holdings based on their historical dividend payments. These screens are, of course, backward-looking, but this step ensures that a firm has an established pattern of paying or growing its dividend--evidence of a commitment of returning cash to shareholders.
3. Market-capitalization weighting. Weighting stocks by their market capitalization tilts holdings toward larger, more stable firms. Alternatively, weighting stocks on the basis of their yield or equal-weighting, may tilt the portfolio toward higher-yielding, smaller and riskier stocks that are more prone to cut their dividends.
4. Caps. Capping single-stock and/or sector weightings is a straightforward way to reduce risk. Unfortunately, many of these caps have been applied only after the damage has been done.
None of these tactics is a silver bullet. No approach can avoid stocks that may cut their dividends altogether. That said, funds that effectively incorporate these approaches to risk reduction into their process may offer better investor outcomes.
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