The Diversified Dividend Aristocrats

May 02, 2005

S&P’s new dividend indexes significantly expand the playing field for dividend investors.

Since the passage of the 2003 dividend tax cut, investors have flocked to dividend funds and indexes like pigeons to popcorns. Consider the iShares Dow Jones Select Dividend Index Fund (DVY):  Introduced in November of 2003, DVY has been one of the fastest growing exchange-traded funds (ETFs) of all time, and now boast assets of over $6 billion.

Despite their success, however, the currently available dividend indexes come with limitations.  Because they select for the highest-yielding stocks on the market, these indexes are inherently biased towards high-yielding sectors of the economy, such as utilities and financials.  They don't represent the "core" investment universe.

This morning, however, Standard and Poor's rolled out new dividend-focused indexes in both the U.S. and Europe that offer a diversified approach to high-yield investing.  Called the "Dividend Aristocrats," these new indexes promise to significantly expand the playing field for dividend investors.

Diversified Dividends

The two new indexes launched by S&P are the S&P 500 Dividend Aristocrats Index and the S&P Europe 350 Dividend Aristocrats Index.  The S&P 500 index tracks the performance of those companies in the S&P 500 with a twenty-five year track record of boosting their dividends; the European index tracks companies in the Europe 350 with a ten-year track record of dividend hikes.  For ease of analysis, this article will focus on the U.S. index.

The key difference between the Dividend Aristocrats index and "traditional" dividend indexes lies in the number of screens each use to select components. 

Competing dividend indexes - such as the Dow Jones Select Dividend Index and the Mergent Dividend Achievers Index (the benchmark for Powershares' dividend ETF, PEY) - use two criteria: First, they screen for companies with a sustained history of boosting their dividends; then, they choose a fixed number of stocks with the highest current yields.

These two criteria combine to create indexes with very high yields, but at a cost of concentrating exposure in sectors with traditionally high payouts - particularly utilities and financials. Indeed, those two sectors make up 61 percent of the Dow Jones index and 78 percent of the Mergent index!

The new S&P index, however, uses only one criterion: It selects all companies in the S&P 500 index with a 25-year history of boosting dividends.  The index does not screen for the highest possible yield. As a result, the S&P index has a much lower yield than its competitors, but it is dramatically more diversified: Utilities and financials make up just 21 percent of the index.  It's like a miniature version of the original S&P 500 - with a higher yield (2.3 percent vs. 1.6 percent for the traditional S&P 500).

For investors, this raises the possibility of substantially replacing traditional large cap index holdings with dividend-screened holdings. That is impossible with the other indexes, because doing so would introduce too much sector risk into a portfolio.

Interestingly, S&P's data shows that investors might want to consider taking dividends into account when selecting a large cap index: The Dividend Aristocrats Index has outperformed the S&P 500, S&P 500 Equal Weight and S&P 500 Barra Value indexes over the past three, five and ten-year periods - with less risk.  Over the past ten years, for example, it's topped the S&P 500 by 2.4 percent/year in total return.

One concern sure to be raised about the index involves turnover. To boost performance, S&P decided to use an equal-weighting methodology for the index, and to rebalance quarterly.  Based on the S&P's own analysis, the equal-weighting methodology boosts turnover for the index above 35 percent/year, based on five-year historical data.  That high turnover could increase costs for any ETFs or index funds designed to track this index.

Comparison Data

There are a number of dividend indexes available on the market today, but the two most popular indexes are the two that form the basis for ETFs: the Dow Jones Select Dividend Index (benchmark for DVY) and the Mergent Dividend Acheivers 50 Index (benchmark fo PEY).  Although the S&P Dividend Aristocrats Index targets a different investment opportunity set than either of these indexes, it's instructive to consider how the three compare:

TABLE 1

Dividend Aristocrats

Dow Jones Select Dividend (DVY)

Mergent Dividend Achievers (PEY)

Components

63

100

50

Years of Raising Dividends

25

5

10

Yield, 12/2004

2.3%

3.53%

3.93%

P/E Ratio

18.6

16.1

17.9

% of Portfolio in Finance and Utilities

21%

61%

78%

 

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