Seeking Alpha
Research analyst, long/short equity, dividend investing, ETF investing
Profile| Send Message| ()  

By Abby Woodham

The most popular domestic and international dividend exchange-traded funds are differentiated by more than just their regional exposure. The domestic ETFs with the largest share of inflow over the past year are constructed to offer total return by focusing on high-quality dividend payers. As a result, these funds tend to have yields only slightly higher than that of the S&P 500, but they outperform over time on both a total return and risk-adjusted basis. The most popular international dividend ETFs are somewhat riskier and boast dividend yields that tend to be significantly higher than that of the popular benchmark MSCI EAFE Index. These ETFs are more speculative and volatile than the quality dividend strategies that are so popular for U.S. stocks. Investors looking for total return should carefully examine international dividend ETFs to ensure they're not unwittingly taking on more risk than expected.

Top Domestic Dividend ETFs Eschew High Yield for Total Return
The case for dividends is strong, both in the U.S. and abroad. Historically, dividends have been the primary driver of stock market total return: reinvested dividends generated almost half of the annualized return of both the domestic stock market and the MSCI EAFE Index over the past century. Dividend-paying stocks also dependably outperformed nonpayers during most time periods, and with less volatility. By paying and maintaining (or increasing) a dividend, managers must allocate cash prudently. Companies that consistently pay a dividend generally have dependable cash flow, and various studies show that a high dividend payout ratio is correlated with faster future earnings growth. This is the case for individual companies as well as the broad market. In aggregate, dividends provide income and also signal shareholder-oriented and disciplined management.

The large domestic dividend ETFs are distinguished by how they screen constituents for quality and weight them. Most incorporate some form of quality screen that goes beyond the typical size and liquidity requirements imposed by most indexes, which is why their yield rarely rises above 4%. We like dividend ETFs that require dividend growth over a long period of time, preferably more than 10 years, to demonstrate the ability to grow a dividend over more than one market cycle. A 2012 study by Ned Davis Research showed that dividend-growing companies outperformed the broad dividend-paying segment with less volatility. Companies that consistently grow their dividends can meaningfully boost total return with that growth alone: a firm with a 1.5% dividend and 10% growth rate will outpace a stagnant 3% dividend within six years. Popular ETFs Vanguard Dividend Appreciation (VIG) and SPDR S&P Dividend (SDY) require 10 and 20 years of dividend increases, respectively, and Schwab U.S. Dividend Equity ETF (SCHD) only allows constituents that have not cut dividends for 10 years. Other domestic ETFs use less-rigorous guidelines but largely succeed at keeping distressed names out of their portfolios. Even Vanguard High Dividend Yield Index ETF (VYM), the largest dividend ETF to target a higher yield, buys essentially the highest-yielding third of the U.S. market, weighted by market cap--not a terribly risky methodology.

Because the international market is historically higher-yielding than the domestic market, investors could be forgiven for assuming that the comparatively higher yield on the popular ETFs does not involve more risk than their domestic counterparts. In fact, the story is the same: their higher yield comes with more risk. Domestic stocks that attempt to maximize dividend income do not target the qualities that make dividend-paying firms outperform historically. After sorting U.S. stocks from 1928 to the present day into dividend-paying and non-dividend-paying groups, analysis shows that equities with the highest yield did not produce the best risk-adjusted or total return. Optimal return was generated by the seventh decile, or fourth quintile of yield. The highest-yielding stocks performed poorly because many of them were distressed, out-of-favor firms with an unsustainable dividend. Unsurprisingly, the value loading of a dividend portfolio increased in tandem with its yield.

International Dividends Have Enticing Yields, but Buyer Beware
Most international dividend ETFs use less-stringent restrictions, and the ones attracting the largest inflows are the highest-yielding of the group. Only one, PowerShares International Dividend Achievers (PID), uses dividend growth (five years) as its primary screen. Instead of sorting for dividend growth, high-yielding international ETFs use fundamental screens or none at all. The other international dividend ETFs weight by a variant of dividend yield, even the quality-targeting PID.

Targeting the highest-yielding companies can be considered a contrarian strategy, as many of these companies are distressed and out of favor. Stocks usually provide high yield when their price has been lowered because of distress in the economy or in anticipation of bland earnings growth or a dividend cut. During a market downturn, yield-weighting particularly tilts to companies trading at a discount. Without a stringent quality screen in place, weighting by yield adds significant risk. The resulting portfolios are usually deeper value than the popular U.S. stock ETFs. The riskier international dividend ETFs significantly lagged large foreign value stocks in 2008, while U.S. equity quality dividend ETFs saw less drawdown or even outperformed. We also note that iShares Dow Jones International Select Dividend Index (IDV) and SPDR S&P International Dividend (DWX) saw their dividends fall by about 60% in 2009, as constituents presumably cut their dividends. The popular U.S. dividend funds saw significantly fewer declines in dividends in 2009.

Balancing Yield and Risk
Our favorite is PID, which is the only ETF to offer quality dividends with a strategy similar to that of our domestic ETF favorites. It is the most appropriate international dividend holding for total return investors. Like the quality domestic ETFs, its yield is not higher than that offered by broad international funds like iShares MSCI EAFE Index (EFA). PID has seen healthy inflow over the past year, but nowhere near the level of the more-speculative ETFs. PID's five-year dividend growth screen would be considered insufficient for a top domestic dividend fund, but it stands out among international dividend funds. Its holdings are more durable, which resulted in lower volatility and higher risk-adjusted return over the past five years. PID has a blended portfolio with valuation metrics more expensive than its competitors'. PID is expensive, charging 0.56% a year.

DWX, which attracted almost $500 million of inflow over the past year, requires constituents to have paid dividends for the past three years, with positive three-year EPS and profitability. DWX provides 6% or higher yield, but its lower-quality portfolio is the most volatile of any international dividend ETF. DWX charges a relatively cheap expense ratio of 0.45%. DWX is most appropriate for income investors willing to sacrifice price appreciation for higher yield.

IDV was the most popular ETF over the past year, drawing almost $1 billion of inflow. It requires constituents to have raised dividends over the past three years without halting payment. Constituents are cut if their payout ratio is more than 150% of their country's average. These screens are more quality-focused than DWX's, which has resulted in less volatility historically. IDV was still more volatile than the MSCI EAFE Index over the past five years. This ETF yields 4.57% as of this writing, offering a balance between PID's quality and DWX's risky high yield. It costs 0.50% a year, which is about average.

Another option is WisdomTree DEFA (DWM), the most diversified international dividend ETF, with almost 700 holdings. It is the only large fund in its category to track an index that weights each constituent in proportion to their share of the total dollar value of dividends that all constituents paid, which results in a large-cap and slight quality tilt. However, like other WisdomTree offerings, DWM does not use quality screens other than size and liquidity. This fund is almost perfectly correlated with the MSCI EAFE Index. DWM's price of 0.48% a year is average but expensive compared with plain-vanilla MSCI EAFE ETFs like iShares Core MSCI EAFE (IEFA), which charges 0.14%.

Tax and Currency: A Consideration for All
Two issues can reduce the dividend actually delivered to U.S. investors from international dividend funds: currency and taxes. Exchange rates are mean-reverting in the long term, but over the short term exchange rates can add volatility to a fund. Most international ETFs do not hedge their currency exposure, so recently the strong performance of the dollar has weighed on international equities. You can view a fund's regional holdings under the portfolio tab after pulling up an ETF or mutual fund's Quote page on Morningstar.com.

International dividend funds are subject to foreign withholding taxes, usually about 9%. Investors can claim the withheld amount as a tax credit when the fund is held in a taxable account. Because the yield of international funds is calculated net of the withheld amount, investors who claim the tax credit will receive a higher yield than the quoted amount. However, if an international fund is held in a tax-deferred account, the withheld portion is lost forever.

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: How Risky Are International Dividend ETFs?