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By Samuel Lee

The emerging-markets story is all about growth, the red-hot kind. Paradoxically, the best way to benefit from economic growth may be to hold boring, dividend-paying stocks. Compared with the rich world, emerging markets have weaker rule of law, feeble protection for minority shareholders, and poorer management--all factors that have fed into relatively poor stock-market returns for fast-growing economies in the past. Holding dividend-payers is one of the few ways individual investors can mitigate these issues. Before we delve into the case for dividends in emerging markets, it's worth pointing out why dividends are good in general.

King Dividend
The small, regular payments companies make are powerful. London Business School professors Elroy Dimson, Paul Marsh, and Mike Staunton found that of the U.S. stock market's 6.22% annualized real return earned from 1900 to 2010, 4.2 percentage points came from dividends, 1.4 percentage points from dividend growth, and the rest from investors' willingness to pay more for a dollar of dividends. Of all 19 major markets Dimson, Marsh, and Staunton looked at for the period from 1900 to 2010, Sweden's yawn-worthy 1.77% dividend growth rate was the highest.

With dividends accounting for the lion's share of past market returns worldwide, it's no surprise then that dividend-payers have outperformed nonpayers in almost every country studied, both on risk-adjusted and absolute measures. To rub salt in the wound of efficient-markets models, the high-yield stocks had a lower beta, or sensitivity to the market's performance, than nonyielding stocks. Risk-based theories have to add ugly epicycles to explain away these findings. The simplest explanation is best: Investors and managers have tended to overprice growth.

Is It Different This Time?
Focusing on dividends seems stodgy and quaint when emerging markets have been growing at a breakneck pace, with corporate profits coming along for the ride. Sure, emerging markets have experienced booms before, only to have major busts. But many argue that this time is different, that emerging markets will experience decades of high growth. Even if we accept this argument, we can't assume higher equity returns. The link between stock-market returns and gross domestic product growth has historically been weak, showing almost no correlation over long periods. Why has this been the case?

GDP and total earnings growth tend to track each other, in principle allowing earnings per share to grow as fast as GDP--assuming no new share issuances, no new enterprises. In reality, a fast-growing economy sucks in capital from domestic savers and foreign investors. Factories are bought, old firms fail, and creative destruction takes its toll. Old shareholders are diluted away, which is why no stock market has grown dividends by more than 2% annualized over the 20th century. Rob Arnott and William Bernstein calculated that this dilution drag has led earnings-per-share growth to lag GDP growth in the United States by about 2%. A later study found that dilution drag in emerging markets was 7% annualized from 1990 to 2003. Using data for the MSCI Emerging Markets Index, I also found a 7% dilution drag from 2007 to 2011.

The big problem with all this dilution is that it signals poor returns. Managers love to build empires with shareholders' capital. They tend to issue shares when they're overvalued--otherwise, why not take on debt? Dividend stocks, to no one's surprise, don't issue as many shares, being in the late stage of the corporate life cycle. In a market where accounting measures and manager quality are suspect, dividends are excellent constraints on managerial misbehavior and a powerful signal of profitability, both current and future.

Emerging-Markets Dividend ETFs
Investors have several good options for emerging-markets dividend stocks. As variations on the same theme, they have generous helpings of Brazilian and Taiwanese stocks, telecom firms, and fewer resource stocks. Despite the commodity underweighting, the exchange-traded funds have been major beneficiaries of China's infrastructure boom through indirect macroeconomic linkages, so they've tracked commodity prices.

WisdomTree Emerging Markets Equity Income (NYSEARCA:DEM)
The granddaddy of emerging-markets dividend ETFs carries a forward-looking 4% yield and a 0.63% annual charge. Every year it picks the top 30% of stocks from a prescreened list of emerging-markets dividend stocks and then weights them by their total dividends. It has a big 26% financials weighting--a cause for concern if you're not comfortable with the pace and quality of credit creation in emerging markets.

SPDR S&P Emerging Markets Dividend ETF (NYSEARCA:EDIV)
State Street's fund is marginally cheaper than DEM and carries a 5.9% forward yield. Unlike DEM, this fund is yield weighted, which might boost its risks. It weeds out distressed firms by requiring stocks to have positive cumulative three-year earnings growth and positive per-share earnings during the past year. The fund caps sector, counter, and stock weightings. Be warned that EDIV isn't as liquid as DEM and can trade at noticeable discounts or premiums to net asset value.

WisdomTree Emerging Markets SmallCap Dividend (NYSEARCA:DGS)
This is DEM's small-cap sibling. Its 3.3% yield isn't as impressive as DEM's and EDIV's. However, its sector weightings are the most evenly distributed of all the ETFs, and its firms have a more domestic clientele.

A version of this article appeared Aug. 17, 2011.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.

Source: The Case For Emerging-Markets Dividend Funds