The quality factor is often associated with dividends and there are plenty of exchange traded funds that offer investors exposure to a combination of quality and dividend-paying stocks. That group includes the FlexShares Quality Dividend Index Fund (NYSEArca: QDF).
QDF emphasizes the quality factor where a company’s ability to generate free cash, dividend growth and stability are integral factors. The ETF tries to reflect the performance of the Northern Trust Quality Dividend Index, which holds high-quality income-oriented U.S. companies with a targeted overall beta similar to the Northern Trust 1250 Index, or the parent index. QDF’s quality emphasis implies a safer payout and more room for potential dividend growth.
Importantly, QDF skirts the risks associated with owning high dividend stocks, an important trait for investors looking for sustainable, long-term dividend growth.
“This fund strives to sidestep this risk by balancing profitability and yield. If a stock is more profitable, it should be able to maintain its dividend during a market downtown or raise its payout ratio in the future. Although this fund’s profitability tilt helps it avoid the riskier, highest-yielding stocks, its yield has consistently topped the category average by 30%,” said Morningstar in a recent note.
QDF screens for management efficiency, profitability and cash flow. Each company has to show management efficiency, or firms that efficiently deploy capital and make smart financing decisions. Companies with wider profit margins are better positions to grow and maintain dividends than those with slimmer margins. Additionally, firms that can meet debt obligations and day-to-day liquidity needs are better capable of maintaining dividends.
Another element that has been critical to QDF’s success is the FlexShares emphasis on management efficiency and a company’s ability to generate cash. Focusing on return on assets and return on capital, derivatives of the quality factor, over more prosaic measures such as dividend increase streaks.
QDF features a heavy cyclical tilt, which can be a positive trait in advance of higher U.S. interest rates. The financial services, technology and consumer discretionary sectors combine for nearly half of the ETF’s weight. Conversely, QDF’s exposure to the rate-sensitive telecom and utilities sectors is relatively modest as is the fund’s allocations to the downtrodden energy and materials groups.
“Drawbacks to this fund include its opaque process and short live track record. Because this fund uses a proprietary quality scoring system and optimizes its holdings with narrow constraints, it’s difficult to determine how the fund’s holdings will shake out at each quarterly reconstitution,” adds Morningstar.
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