ETF issuers are designing increasingly sophisticated funds to help investors access dividend income. But detractors say they remain too backward-looking.
[This article originally appeared on our sister site, IndexUniverse.eu.]
We live in interesting times. Current market conditions are unusual and require exceptional investment skill. An unholy combination of quantitative easing and a flight away from risky assets has helped to create an exceptionally low-yield environment. Investors are seeking decent returns with a febrile intensity.
One of the quirks of the current environment is that corporate balance sheets and cash flows are in much better financial shape than those of governments. But investor uncertainty is dampening equity market valuations. The net result is that the dividend yield for many companies is easily outstripping returns on both government debt and many investment grade corporate bonds.
Investors are taking a page out of the 1950s play book and are no longer primarily seeking capital growth from equities but instead focusing on dividend income. The result? An explosion of interest in dividend income funds.
Aymeric Poizot, a managing director in the fund and asset manager group at Fitch Ratings, says: “Over the long run, the biggest contribution to total shareholder returns comes from dividend income. In a low growth environment, dividend income becomes even more important as capital returns dwindle.”
This investment strategy has traditionally been one that only an active manager could provide, cherry picking the best yielding stocks for a fund. But investors are now confronted with an increasing variety of formula-driven, passive dividend funds, in the form of equity dividend ETFs.
Dodd Kittsley, global head of ETP research for BlackRock, says: “There has been a significant interest in equity dividend income products. By the end of June, assets under management in these funds had reached just over US$62 billion, with US$10 billion of new cash flows into this product group in the year to date.”
There is, however, a significant regional split, according to Kittsley. Investor interest in dividend-focused ETFs is heavily concentrated in US-listed products. These command over 80 percent of worldwide assets under management (AUM) and have attracted more than 90 percent of this year’s cash flows into such funds.
“While the trend is not quite as pronounced in Europe, we‘ve seen new cash flows of over US$500 million so far in 2012, which is almost the same as the inflows for the whole of last year,” he adds. “European dividend-focused ETFs have AUM of US$4.4 billion.”
Investors are choosing ETFs rather than the more traditional actively managed route into high-yielding equity because the providers of exchange-traded funds are offering more sophisticated ways of choosing dividend-paying stocks than simply selecting the highest-yielding equities from a universe of stocks. “Using rule-based methodologies we can create very different economic exposures. These are very similar to the tools that an active manager uses: we can screen for quality, dividend sustainability and payout ratios,” says Kittsley.
These rules can be finely tuned to factors such as payout ratios of more than 60 percent or years of successive dividend increases. “Many of the funds are weighted by the dividend yield of the underlying securities,” adds Kittsley.
Investors are now able in a single trade to buy a diversified basket of securities that are desirable. “We’ve seen a lot of interest in securities with high-quality stocks with sustainable dividend income,” he says.
If the circumstances at a company change suddenly—for example, it cuts its dividend—it can be dropped immediately from the index underlying the ETF. If there’s an early warning sign, such as the payout ratio exceeding 60 percent, then the stock will be booted out at the next index rebalancing date.
While these factors undoubtedly help to keep the right constituents in the investment vehicle, these actions still might not be timely enough. An active manager keeping a close watch on his portfolio could spot trouble brewing before it was reflected in a dividend cut, for example.
“That’s why some of the indices that the equity income ETFs are based upon do have additional screening criteria relating to quality,” adds Kittsley.
But even with the best possible design, these passive vehicles will be largely based on historical data. And any such approach is flawed by design, says Fitch’s Poizot: “It’s very risky to be completely backward-looking today because the environment is so uncertain that the past is likely to be an exceptionally bad indicator of the future.”