Dividend Stock ETFs: Trading Growth For Yield

| About: SPDR Dividend (SDY)

Dividend stock ETFs can be a convenient way to boost income relative to broad-based stock ETFs while maintaining a similarly high level of diversification. My previous article highlighted a few ETF choices and provided comparison across yield, risk, and valuation. However, a commenter inquired about the growth of the dividends. Accurate dividend growth was difficult to compare across the ETFs for a couple of reasons. For example, the WisdomTree High-Yielding Equity Fund (NYSEARCA:DHS) and WisdomTree Large Cap Dividend Fund (NYSEARCA:DLN) had recently converted from quarterly dividends to monthly dividends. The following table for DHS highlights this transition occurring in for June 2012.

DHS Dividends

3/22/2013 0.13
2/19/2013 0.145
1/22/2013 0.153
12/24/2012 0.191
11/26/2012 0.228
10/22/2012 0.165
9/24/2012 0.136
8/27/2012 0.156
7/23/2012 0.147
6/25/2012 0.404
3/26/2012 0.411
12/21/2011 0.381
9/26/2011 0.363
6/22/2011 0.36
3/21/2011 0.313

Source: Yahoo Finance

The other challenge was that some payments did not seem to occur. According to Yahoo Finance, there was no March 2010 dividend for SPDR S&P Dividend ETF (NYSEARCA:SDY). Nor was there a dividend for Vanguard High Dividend Yield ETF (NYSEARCA:VYM) in June 2009. These missing dividends created additional troubles for comparisons, especially since the other dividends in those years appeared to be appropriately sized, had the missing dividend been there. However, with the limited data and some adjustments, it appeared that SDY had lower dividend growth than SPDR S&P 500 Trust ETF (NYSEARCA:SPY) - not exactly the conclusion I expected. By looking at the 2006 annual dividends and 2012 annual dividends, I calculated that SDY only grew at a 1.3% annual rate when compared to SPY's 4.0% - a significant contrast.

SDY offers superior yield, but at the expense of growth

After reading the comment, I went back and crunched some more numbers, in fact, I crunched a lot more numbers. I took the complete holdings of both SDY and SPY and looked up the historical dividend growth, P/E ratio, and long-term target EPS growth for each stock - essentially 500 in all. SDY's holdings are essentially a subset of SPY's holdings.

Taking these data points and weighting them appropriately, one can create a bottoms up composite payout ratio, historical growth rates, and future estimated growth rates for the ETFs themselves. The following table shows the comparisons for SPY and SDY:

Key Dividend Metrics for SPY and SDY

Metric Weighting SPY SDY
Historical 5 Year Dividend Growth Dividend Weighted 9.1% 6.1%
LT EPS Growth Earnings Weighted 15.2% 8.5%
LT EPS Growth Dividend Weighted 8.3% 7.8%
Payout ratio Combination 30.0% 46.9%

Source: SPDR for ETF holdings, Zacks.com for stock metrics, and Author Calculations

This table is very interesting. First, the dividends for SPY have a better five year growth rate than SDY on a historical basis, which is what we confirmed from the earlier snapshot of Yahoo Finance data. The difference in the rates will be due to the fact that the Yahoo data appropriately adjusts the weightings for each dividend and my approach ignores that refinement and thus is biased towards stocks with higher dividend growth rates, skewing both results up. However, the difference between the two rates are approximately the same at 3%, which is the key observation.

History is nice, but investors care about the future, so I also looked at forward growth rates. I used EPS growth as a proxy for dividend growth and in both weighting cases, SPY was superior. When weighted based on earnings the spread was larger than when based on dividends. Using dividends to weight the average makes the assumption that the payout ratio remains fixed over time, while weighting with earnings more closely assumes that all payout ratios converge to a single number. Either case is flawed, but should provide a set of bounds.

The final metric is also quite telling. The average payout ratio for SPY is 30%, while it is 47% for SDY. This circles back to support the explanation of growth. A higher payout ratio is indicative of a more mature company that has fewer reinvestment opportunities. Companies that pay out more of their earnings relative to reinvestment should grow at a slower rate than other companies. I believe that this is exactly what is happening between these two ETFs. Furthermore, more SPY stocks can offer dividend growth by raising the payout ratio. In fact, if they had the same payout ratios, SPY would have a higher yield than SDY. (47/30 * 2% yield is actually greater than SDY's 2.9% yield)

Balancing Growth vs. Yield

So investors are now left with the question, well which one is better? If an investor is looking to generate income today, SDY is probably superior, simply by its higher yield. If one is not looking to generate immediate income today, but rather 20 years from now, I think SPY is superior.

Dividend Equality Analysis

Metric SPY SDY
Closing Price 154.14 65.39
Dividend Yield 2.0% 2.9%
Shares for $100k 649 1,529
Current Annual dividends on $100k 2,000 2,900
Growth Rate 9.1% 6.1%
Dividends in 14 Years 6,770 6,644

Source: Yahoo Finance, Author Calculations. Note that current yields were rounded to just two significant digits.

This table illustrates some simple math. I also used the historical dividend growth rate to project forward. It shows that SPY would catch SDY in 14 years. The point of this is that each investor has to value the trade off of growth and yield. The flaw is that SDY can change over time. Presumably, the managers will be identifying and purchasing new stocks with higher yields that have benefited from years of dividend growth. In doing so, they can probably avoid this scenario.

So like a lot of investing, the profits are in the details. This also does not address the notion that principal could appreciate differently as well.

Disclosure: I am long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security. I am long SPY.

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