An Investing Expert Explains How He Screens For the Best Dividend ETFs

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One of my favorite ETF “cautionary tales” when it comes to yield-chasing investors is the Global X SuperDividend ETF (SDIV). On the surface, this ETF seems pretty attractive – for a 0.58% expense ratio, investors receive exposure to 100 of the highest-yielding global dividend stocks. Currently, the ETF pays a scorching high trailing 12-month yield of 15.45%.

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The total returns (i.e., with distributions reinvested) show an entirely different angle to this ETF. As of April 30th, 2023, SDIV has returned a disappointing -3.49% annualized return over the last 10 years. The lesson here? Chasing yields is tempting, but it is rarely the best way to implement a successful, sustainable, and well-performing long-term dividend investing strategy.

So, what does work? To get some ideas, I grabbed a few quotes from Wes Moss. Wes is the Managing Partner and Chief Investment Strategist of Capital Investment Advisors, a registered investment advisor firm with over $4 billion in assets under management. He is also the host of the Retire Sooner podcast, a Certified Financial Planner (CFP), and the author of three books on retirement planning. Here’s what he had to say about dividend ETFs.

Wes Doesn’t Like High Yields

As noted earlier, yield-chasing with dividend ETFs can often result in bitter disappointment. There’s no free lunch in investing, and a high yield should be viewed with suspicion. Investors often speak of “yield traps”, which refer to stocks or ETFs with an alluringly high dividend.

The “trap” comes in when the high yield can be so attractive that it blinds investors to the underlying risks associated with the investment. A high yield can be a sign of financial instability in the company or a declining business, which may lead to a reduction in future dividends or a fall in share price.

Here’s what exactly Wes had to say about chasing high yields:

“While lots of companies pay dividends, they aren’t all the same. The highest dividend yielding stocks typically fall into the first quintile, which represents the top 20% of dividend yield stocks in a given market or index. While those significant cash payments can be attractive for income-oriented investors, those high dividend yields can sometimes be a red flag for investors.

“A company may offer a high dividend yield because its share price has fallen significantly, which could indicate financial distress or other issues. Additionally, a high dividend yield can sometimes be unsustainable if a company is paying out more in dividends than it can afford based on its earnings and cash flow. These high dividend yielders have actually exhibited more volatility during times of financial stress such as the 2008/2009 financial crisis and the pandemic in 2020.”

Wes Looks at These Metrics Instead

At the end of the day, yield is only one metric to screen dividend stocks for. In a previous article comparing the Schwab US Dividend Equity ETF (SCHD) against the iShares Core Dividend Growth ETF (DGRO), I noted that investors might be better off assessing dividend ETFs for quality exposure – specifically, the Fama-French factors of conservative investments and robust profitability.

Here are some of the ways Wes screens for quality:

“The real sweet spot for growth and income when it comes to dividend paying stocks is typically in the ‘goldilocks’ second and third quintile range. These companies typically have lengthy track records of sustained profitability, earnings, and free cash flow growth. They also typically have strong balance sheets that aren’t laden with excessive debt. This enables them to not only continue paying dividends, but also increase them over time in a sustainable manner.”

“In fact, looking at the peak-to-trough periods in each of the past 19 years, the Morningstar U.S. Dividend Growth Index experienced only about 84% of the downside seen by the market. The Morningstar U.S. Dividend Growth Index also outperformed the S&P 500 90% of the time during this period. All of this is to say that these dividend growers have historically produced better returns with less volatility.”

Putting It All Into Play

With this information in mind, I’d like to put forward some dividend ETFs that fit Wes’ criteria. Keep in mind that these are my personal picks, and should not be construed as investment advice on Wes’ part. They are simply my interpretation of the criteria he put forth earlier.

First up is the Vanguard Dividend Appreciation ETF (VIG), which I covered in an earlier article. This popular ETF tracks the S&P U.S. Dividend Growers Index, which has two main requirements:

  1. Screen holdings for a history of consistently increasing dividends every year for at least 10 consecutive years; and
  2. Excludes the top 25% highest-yielding eligible stocks from the index.

This criterion satisfies some of Wes’ criteria, namely the part about excluding the top quintile of stocks based on yield and looking for a long track record of dividend growth.

The second ETF worth looking at is DGRO, which I did a deep dive earlier on. This ETF tracks the aforementioned Morningstar U.S. Dividend Growth Index, which Wes noted has historically performed favorably compared to the S&P 500.

DGRO and its index satisfies some of Wes’ criteria for quality in terms of yield ranking, profitability, earnings, and free cash flow growth by screening for:

  1. At least five consecutive years of dividend growth.
  2. Positive consensus earnings forecast and payout ratio of less than 75%.
  3. Does not have a dividend yield in the top 10%.

Here’s what the historical performance of VIG, DGRO, and SDIV look like compared to the SPDR S&P 500 ETF (SPY). Keep in mind that this backtest is hypothetical in nature, does not reflect actual investment results and is not a guarantee of future results. It also does not account for trading commissions and bid-ask spreads. In any case, I think it speaks for itself.

© Provided by ETF Focus on The Street
Source: Portfolio Visualizer

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