Investors who are looking for ways to diversify in a tumultuous market may want to consider exchange traded fund strategies that identify quality dividends.
In the recent webcast, Navigating Current Markets and Dividend Investment Strategies, Meggan Friedman, Senior Investment Sales Strategist, Northern Trust Asset Management, underscored the volatility shocks that have become more frequent and extreme in recent years, with the more recent 21.6 daily point increase in the CBOE Volatility Index, a gauge of market fear, during the COVID-19 panic selling. In comparison, the global financial crisis saw a VIX daily point increase of 16.5 during the height of the selling.
Meanwhile, due to aggressive monetary policies and quantitative easing programs to help support economic growth, fixed-income investors have witnessed equity yields outpace bond yields, and this trend is unlikely to revert any time soon.
“With U.S. interest rates at record lows and investors looking for ways to bolster investment returns, equity solutions that have historically offered high dividend yields look comparatively attractive,” Friedman said.
However, Friedman warned that those yields frequently comes additional potential risks such as outsized sector bets and the possibility that those yields are not sustainable. These risks can also be exacerbated by the challenges businesses across many industries are currently facing during the coronavirus pandemic, and by the requirement that public companies receiving government aid via the CARES Act may have to cut dividends for the duration of the loan plus one year.
Dividends have been a historical driver of overall returns for investors. Looking at the Russell 1000 benchmark, dividends have contributed to 2.76% of the index’s total return since its inception. While investors can still augment their portfolio through dividends, it is also important to be selective in a bid to focus on areas of strength.
“We believe relying heavily on historical high yield sectors such as financials, energy, industrials and consumer discretionary, can be detrimental to yield and performance,” Friedman said, pointing out that these areas have also suffered from the highest concentration of sector dividend cuts.
Alternatively, Friedman argued that a quantitative, multi-factor model methodology that screens for quality and dividend yield may be a better way to target dividend payers efficiently. Specifically, FlexShares focuses on the core financial health of a dividend-paying company to address some of the shortcomings of other dividend-themed strategies, screening for management efficiency, profitability, and cash flow as a means of quality control.
FlexShares’ quality dividend indexing methodology targets management efficiency or quantitative evaluation of a firm’s deployment of capital and its financing decisions. By using a management efficiency screen, the index can screen out firms that aggressively pursue capital expenditures and additional financing, which typically lose flexibility in both advantageous and challenging partitions of the market cycle.
A profitability score is also taken based on a firm’s relative competitive advantage across several metrics. Firms with wider margins typically are better positioned to expand compared to those with tighter margins.
Lastly, cash flow provides a better understanding of liquidity levels for a company. A firm that does not meet its debt obligations and day-to-day liquidity needs are likely to be poorly positioned to take advantage of future opportunities or have a financial cushion during downturns.
This methodology is the underlying indexing strategy found in FlexShares’ suite of smart beta, quality dividend ETFs, including the FlexShares Quality Dividend Index Fund (NYSEArca: QDF), FlexShares Quality Dividend Dynamic Index Fund (NYSEArca: QDYN), FlexShares Quality Dividend Defensive Index Fund (NYSEArca: QDEF), FlexShares International Quality Dividend Index Fund (NYSEArca: IQDF), FlexShares International Quality Dividend Defensive Index Fund (NYSEArca: IQDE) and FlexShares International Quality Dividend Dynamic Index Fund (NYSEArca: IQDY).
Financial advisors who are interested in learning more about dividend strategies can watch the webcast here on demand.