Finding the Best Dividend Fund - Advisor Perspectives

Finding the Best Dividend Fund

By Geoff Considine June 5, 2012

Assets are flowing into dividend-stock funds, as income-seeking investors look for alternatives to the low yields in the fixed-income markets. But many experts are warning that those investors are setting themselves up for significant losses. Using an objective methodology that assesses tradeoff between yield and risk, we can determine those funds that investors should prefer ? and a few they should avoid.

One crucial thing about dividend-focused investing is that it is driven in large part by aging baby boomers, whose goal it is to construct de-accumulation portfolios with predictable income and low volatility. In addition, market volatility in recent years has made steady dividend payments especially attractive.

Those experts who caution against dividend funds warn that older investors are replacing low-yield bonds in their portfolios with riskier dividend stocks, inadvertently increasing portfolio risk at a point in their lives when they should be doing the opposite.

I will start by examining the key arguments in favor of dividend-oriented investing. I then explore the major classes of dividend-generating ETFs and mutual funds and compare them using a methodology that compares risk to yield, ultimately determining whether the higher yields that they offer justify the risks.

Elements of dividend investing

Dividends have historically made up a substantial portion of the total returns from equities. A recent article by Richard Skaggs, chief equity analyst at Loomis Sayles, provided updated statistics. Over the past 30 years, for example, dividends have provided 45% of the total return from the S&P 500.

While many advisors focus on total return, my research shows that six factors justify favoring dividend-paying stocks:

1. Better estimation of risk for returns 2. More rapid verification of return and yield estimates 3. Higher quality of earnings 4. Better alignment of incentives between corporate executives and shareholders 5. Simplicity for retirement investors 6. Increased attractiveness if the New Normal plays out

To estimate the future returns from any investment, one of the important sources of uncertainty is estimation risk. This is the risk that comes from our limited ability to estimate

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expected returns. Given that future returns are connected to future earnings, the research that shows that dividend-paying stocks have higher-quality earnings indicates there is less estimation risk associated with dividend-paying stocks than non-dividend payers.

A related advantage to dividend investing is what I refer to as verifiability. If I create a stock portfolio with an expected annual average return of 8% per year, I may have to wait for a very long time before I can confirm that my expected return figure was correct. If the portfolio ?loses 8% in the first year, market volatility is likely to blame ? but it will take several years to tell. Dividend-paying stocks sidestep this problem by providing returns via income that are verifiable quarter-by-quarter. If I hold a dividend-paying portfolio that does not provide its estimated 6% yield, there is clearly something wrong with my expectation.

Managers at firms that pay dividends have financial incentives more aligned with the interests of investors than those of executives at other companies. Management will focus on maintaining dividends, whereas at non-dividend paying companies, managers are more likely to hold substantial stock option grants. Because they are judged on the basis of price appreciation, and because their stock grants give them an incentive to focus on short-term price gains rather than long-term earnings quality, these managers are more likely to take risks.

It also helps that dividend-paying stocks are a key component of income portfolios, which are gaining popularity in de-accumulation strategies. Many retirees want to consume only the dividends or other sources of income generated by their portfolios, in order to reduce the risks of totally depleting their portfolios.

Finally, dividends will be attractive if the New Normal worldview described by Bill Gross and Mohammed El-Erian plays out. This outlook suggests economic growth will slow in the developing world, and that asset returns will be more modest that their historical norms. Accordingly, investors will favor dividends and drive up the prices of those stocks.

The major problem for dividend investors, however, is that dividend yields rise when companies are in distress. Facing adverse conditions that cause its stock price to fall, a company will be reluctant to cut its dividend, fearing the negative signal to investors. With a constant dividend payment and a falling stock price, yield rises. Very high yields can be a sign of distress and warn of an impending dividend cut; this is the so-called value trap.

Against this backdrop, let's explore the mutual funds and ETFs that focus on dividend stocks.

Funds for exposure to dividend stocks

The simplest way for investors and advisors to invest in dividend-paying stocks is through ETFs or mutual funds. Currently, those funds have yields as high as 6.8%, but those highyield funds come with risks. The question is whether the risks associated with higher-yield

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alternatives are too high. Examining the range of dividend-focused ETFs provides an answer. ETFs Index-based ETFs, such as the SPDR S&P Dividend ETF (SDY) and the Powershares High-Yield Equity Dividend Achievers ETF (PEY) provide a good starting point to explore dividend funds. PEY has a yield of 3.66% and SDY yields 3.11%. SDY tracks the S&P High-Yield Dividend Aristocrats index, which draws from a set of companies that have 25year track records of maintaining and/or raising their dividends. PEY tracks the Mergent Dividend Achievers 50 Index, which contains domestic stocks with high current yield and consistent growth in dividends. The yields on SDY and PEY can be used as a baseline for judging other dividend-paying funds. The SPDR International Dividend ETF (DWX), for example, nearly doubles their yields at 6.37%. How do we compare the relative tradeoff of yield vs. risk between SDY and PEY and a fund like DWX? A simple but highly informative measure is to compare yield and historical volatility. The table below compares the yields of a number of stock ETFs with high dividends to their historical volatilities. I selected this list of ETFs using a screen for equity funds with the highest yields, also including a long-term Treasury bond ETF (TLT) for reference. This table is sorted from highest yield (top) to lowest yield (bottom).

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High-yield dividend ETFs

Fund Name

SPDR S&P INTERNATIONAL TELECOMMUNICATIONS SECTOR ETF SPDR S&P INTERNATIONAL DIVIDEND ETF WISDOMTREE AUSTRALIA DIVIDEND FUND ISHARES S&P GLOBAL TELECOMMUNICATIONS SECTOR INDEX FUND FIRST TRUST DOW JONES STOXX EUROPEAN SELECT DIVIDEND INDEX SPDR DJ EURO STOXX 50 ETF GUGGENHEIM MULTI-ASSET INCOME ETF WISDOMTREE EUROPE SMALLCAP DIVIDEND FUND SPDR S&P INTERNATIONAL UTILITIES SECTOR ETF GUGGENHEIM INTERNATIONAL MULTI-ASSET INCOME ETF ISHARES MSCI BELGIUM INVESTABLE MARKET INDEX FUND ISHARES MSCI ITALY INDEX FUND FIRST TRUST DOW JONES GLOBAL SELECT DIVIDEND INDEX FUND ISHARES S&P GLOBAL UTILITIES SECTOR INDEX FUND WISDOMTREE GLOBAL EQUITY INCOME FUND SPDR FTSE/MACQUARIE GLOBAL INFRASTRUCTURE 100 ETF ISHARES MSCI EAFE VALUE INDEX FUND VANGUARD EUROPEAN INDEX FUND ISHARES MSCI MALAYSIA INDEX FUND POWERSHARES HIGH YIELD EQUITY DIVIDEND ACHIEVERS PORTFOLIO WISDOMTREE GLOBAL NATURAL RESOURCES FUND ISHARES BARCLAYS 20+ YEAR TREASURY BOND FUND SPDR S&P DIVIDEND ETF

Ticker

IST DWX AUSE IXP FDD FEZ CVY DFE IPU HGI EWK EWI FGD JXI DEW

GII EFV VGK EWM PEY GNAT TLT SDY

Trailing 12-Month Yield 6.8% 6.4% 5.6% 5.3% 5.3% 5.2% 5.1% 5.1% 5.1% 5.0% 4.7% 4.7% 4.7% 4.6% 4.6% 4.5% 4.3% 4.3% 4.1% 3.7% 3.6% 3.3% 3.1%

Trailing 3-Year Volatility 17.9% 23.1% 26.7% 14.2% 21.0% 28.7% 14.3% 25.1% 17.0% 21.1% 24.1% 31.8% 20.0% 13.8% 19.4% 14.2% 21.9% 24.3% 18.0% 14.4% 27.4% 14.8% 13.4%

What immediately jumps out is how important it is to look at volatility. DWX, for example, has much higher volatility than either SDY or PEY, both of whose risk and yield are remarkably similar to those of the long-term Treasury bonds.

The S&P 500 has a trailing 3-year volatility of 15.6%, which provides a risk benchmark. Quite a number of these funds have been much more volatile than the S&P 500.

One note for the close reader of the table above: CVY, an ETF with high yield relative to its risk level, is not a pure equity fund. The fund holds preferred shares, MLPs, and mortgage REITs. Any of the pure equity funds in the list above could generate more yield with the same or lower risk if they were allowed to invest in these asset classes.

Mutual funds

I have performed a similar search to select dividend-focused mutual funds; the same data for these funds can be found in the table below.

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High-yielding dividend mutual funds

Fund Name

HENDERSON GLOBAL EQUITY INCOME EATON VANCE GLOBAL DIVIDEND INCOME FORWARD INTERNATIONAL DIVIDEND INVESTOR EATON VANCE TAX-MANAGED GLOBAL DIV INC ETF MARKET OPPORTUNITY EATON VANCE TAX-MANAGED GLOBAL DIV INC LORD ABBETT INTL DIVIDEND INC HENDERSON EUROPEAN FOCUS PAYDEN VALUE LEADERS OPPENHEIMER INTERNATIONAL SMALL CO INVESCO EUROPEAN SMALL COMPANY VANGUARD EUROPEAN STOCK INDEX FORWARD LARGE CAP DIVIDEND FEDERATED STRATEGIC VALUE DIVIDEND MUTUAL EUROPEAN DFA INTERNATIONAL VALUE FORWARD EMERGING MARKETS AMERICAN CENTURY UTILITIES

Ticker

HFQAX EDIAX FFINX EIDIX ETFOX EADIX LIDAX HFEAX PYVLX OSMAX ESMAX VEURX FFLSX SVAIX MEURX DFIVX PGERX BULIX

Trailing 12-Month Yield 6.7% 6.6% 6.0% 5.7% 5.5% 5.4% 5.1% 4.8% 4.8% 4.3% 4.1% 4.1% 4.0% 3.8% 3.8% 3.7% 3.6% 3.4%

Trailing 3-Year Volatility 14.8% 15.5% 19.3% 14.3% 18.9% 14.6% 20.8% 27.3% 13.7% 26.2% 19.2% 23.7% 14.7% 11.2% 14.5% 23.3% 25.1% 10.9%

The first two funds, HFQAX and EDIAX, have more than twice the yield with only slightly higher risk than SDY. Morningstar classifies HFQAX as a world stock fund with a large value style. It holds 2.6% in cash, 17.9% in U.S. stocks and 79.6% in non-U.S. stocks. On the basis of yield-vs.-risk, this fund is impressive. EDIAX is also classified as large value fund. A concern with these two funds, however, is their very high annual turnover (127% for HFQAX and 124% for EDIAX ), which means that investors are relying on the fund managers' ability, rather than on the persistence of dividends . High turnover also detracts from performance through brokerage costs and bid-ask spread for the fund's trades.

The table above highlights why investors need to be cautious about selecting funds on the basis of yield alone. Oppenheimer International Small Cap fund, OSMAX, has a yield of 4.3%, far above that of the S&P500, for example, but the risk associated with this fund is substantial. Investors owning such a fund are implicitly betting on substantial price appreciation to supplement yield and offset the risk that they assume.

The risk versus yield frontier

I first introduced the idea of creating an efficient frontier for yield versus risk (as opposed to expected total return versus risk) in October 2010.

Overall, the spectrum of risk versus yield for mutual funds is very similar to that for ETFs, as we can see in the chart below.

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