Income-minded investors have turned to dividend-focused ETFs, but not all dividend ETF themes are a like and some may come with drawbacks.
“Blindly focusing on yield, however, could be dangerous to an investment portfolio’s health. A seemingly generous dividend yield may actually signify a weak share price tied to negative news not yet revealed in the quarterly dividend. Yields for a current year are often estimated using the previous year’s dividend yield or by taking the latest quarterly yield, multiplying by four and dividing by the current share price. This explains why investors in dividend stocks must be confident the dividend being paid is sustainable,” according to a FlexShares note.
There are flaws in dividend-focused strategies. For instance, reacting to a reduced dividend after the fact results in holding the dividend-paying security until the next rebalance or potentially after the stock price has reacted to the news. To evaluate consistent dividend payers, a long history is required, which means newer players are excluded from consideration. Short-term changes in the macro environment could affect a company’s ability to maintain or grow dividends.
Alternatively, FlexShares argued that focusing on the core financial health of a dividend-paying company may be a better approach to address some of the shortcomings of other dividend-themed strategies.
“Measuring a company’s core financial health makes it possible to evaluate whether it may increase (or need to decrease) its future dividends. With this approach, the reliance on publicly available financial data means new dividend payers can be evaluated similarly to stocks that have paid dividends for decades. By using several lenses to evaluate financial health, an investor can gain a strong sense of how well-positioned a dividend paying company is for success, and how protected future dividends are under current market and economic environments,” according to FlexShares.
For instance, dividend ETF investors who are seeking stability, along with exposure to the growing U.S. markets, should look to quality instead of chasing after yields through investment options like FlexShares Quality Dividend Index Fund (NYSEArca:QDF), FlexShares Quality Dividend Dynamic Index Fund (NYSEArca:QDYN) and the FlexShares Quality Dividend Defensive Index Fund (NYSEArca:QDEF).
The Dividend Quality Score process is designed to maximize quality and yield while putting several diversification controls into effect through its selection and weighting process. FlexShares’ multi-faceted dividend quality score examines companies based on three factors when determining its dividend quality indexing methodology.
Related: Dividend ETF Investors: Finding Quality in International Markets
Specifically, the smart beta index targets management efficiency or a 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.
By evaluating these different quality facets, FlexShares is better able to determine the likelihood that a company can issue sustainable dividend payouts.
For more information on dividend-generating ideas, visit our dividend ETFs category.