Dividend-themed funds naturally tilt toward value stocks due to their higher yields and because growth stocks are less likely to pay dividends. However, several dividend-themed ETFs have more of a core orientation because they seek out stocks with either strong historical dividend growth or strong potential for future dividend growth. In this article, we first lay the foundation for investing in dividend paying stocks while being cautious about those with the highest yields. We conclude by highlighting five of our favorite ETFs for dividend growth.
The Tale of the Tape
Since 1927, dividend paying stocks have returned 10.4% per year compared to 8.6% for non-payers. This is based on data from Ken French and the author's calculations. We can take this a step further by quintiling dividend paying stocks by yield. The chart below shows returns to non-dividend paying stocks in the left hand column along with dividend paying stocks sorted into quintiles based on yield. Notice that the highest yielding quintile is not actually the best performing. This is due to some value traps that offer a siren song in the form of an attractive yield.
Not only are dividend paying stocks better performing, they are also lower risk. Non-payers had a standard deviation of return of 29.9% compared to 18.2% for dividend payers. This results in better Sharpe Ratios, or ratio of return to risk. The below graph shows the Sharpe Ratio to each of our cohorts. Again we see the superiority of quintile 4, those stocks with attractive yields although not the highest.
Growers vs. Cutters
The analysis above sorted stocks by yield. A number of investment strategies, such as the Dividend Aristocrats, look for companies that have increased dividends. Ned Davis groups stocks by those that grew their dividend, those that maintained their dividend, those that cut their dividend and those that do not pay a dividend. Since 1987, companies that increased dividends performed the best, returning 13.4% compared to 6.7% for those that cut their dividends.
As investors have tilted toward dividend paying stocks in the wake of the tech bubble and the financial crisis, companies have responded by paying more attention to dividends. The percentage of firms paying a dividend troughed in 2002 and is not at its highest level since the 1980's. However, the dividend payout ratio is still low. The dividend payout ratio over the past five years was about 35%, well below the 50% payouts we saw in the 1980's. But a low payout ratio might be a good thing. A study by Pankaj Patel suggests that the best approach to dividend investing is to look for stocks with high yields and low payout ratios. He used a three factor model based on dividend yield, dividend growth and dividend payout ratio. He first dividend-paying stocks into two buckets by yield. He then divided these by dividend growth and took it one step further, grouping by dividend payout ratio. This resulted in 8 buckets. The bucket with high yields, high growth and low payouts performed the best, returning 17.5% between 2000 and 2013. The worst performing bucket returned 11.9% and represented stocks with low yield, low growth and high payouts.
Now that we have seen that yield alone is not the best approach to identifying dividend paying stocks, we will take a look at five ETFs that offer a combination of yield and growth.
iShares Core Dividend Growth ETF (NYSEARCA:DGRO)
DGRO follows a Morningstar index that uses five basic screens. First, stocks must pay qualified dividends. The dividend yield must not be in the top 10% of the screening universe, so it is specifically not looking for the highest yielding companies. Firms must have increased their dividend for five consecutive years. Consensus analyst earnings forecast must be positive. Finally, the dividend payout ratio needs to be less than 75%. The payout ratio measures what share of a company's earnings are paid out as dividends. In theory, growth companies with lots of investment opportunities should have a lower payout. Stocks are weighted by their proportionate share of the total dividends paid by all constituents, which tilts the fund toward mega cap stocks-those that pay the most in dividends. The fund has 425 holdings, with Microsoft (NASDAQ:MSFT), Johnson & Johnson (NYSE:JNJ), General Electric (NYSE:GE) Procter & Gamble (NYSE:PG) and Pfizer (NYSE:PFE) making up the top five holdings. According to Morningstar, stocks in the fund have a long-term earnings growth forecast of 8.0%, a historical growth rate of 1.7% and a return on invested capital of 13.1%. We can compare that to a value-tilted dividend ETF, in this case Vanguard High Dividend Yield (NYSEARCA:VYM). VYM had a long-term earnings growth forecast of 6.8%, a historical growth rate of negative 2.1% and a return on invested capital of 11.0%. DGRO has a razor thin expense ratio of just 0.08% and stocks in the fund recently had a dividend yield of 2.8%.
WisdomTree U.S. Quality Dividend Growth Fund (NASDAQ:DGRW)
DGRW follows a proprietary index that begins with dividend paying stocks that have a market cap greater than $2 billion and have a dividend payout ratio less than 100%. Next, the fund looks for the 300 firms with the best combined rank on growth and quality. Growth is measured by the long-term consensus analyst expected earnings growth forecast and quality is measured as a combination of the three-year average of return on assets and return on equity. The reason that ROA is included with ROE is that it penalizes companies for excessive debt. Like DGRO, holdings are weighted by share of total dividends paid. Of each of the five ETFs mentioned here, DGRW has the highest weight in the technology sector, which typically has had strong dividend growth and the lowest weight in the financial sector. Also unlike the other ETFs in this article, stocks in DGFW do not need to have increased dividends for an arbitrary number of years. The fund recently held 286 stocks and the top five are Coca-Cola (NYSE:KO), Microsoft, Altria Group (NYSE:MO), Apple (NASDAQ:AAPL), and AbbVie (NYSE:ABBV). According to Morningstar, stocks in the fund have a long-term earnings growth forecast of 9.1%, a historical growth rate of 7.5%, and a return on invested capital of 16.9%. Stocks in the fund recently had a yield of 2.7%, gross of the fund's reasonable 0.28% expense ratio.
ProShares S&P 500 Aristocrats ETF (NYSEARCA:NOBL)
NOBL tracks the S&P 500 Dividend Aristocrats, which equally weights stocks from the S&P 500 that have increased dividends for 25 consecutive years. The index has outperformed the S&P 500 with lower volatility since it May 2005 inception and over the past ten years through July 2016, the index returned 11.0% compared to 7.8% for the S&P 500 and had a standard deviation of 14.1% compared to 15.3% for the S&P 500. The index currently has 50 constituents. If that number should drop to 40, the number of years of dividend increases required for index inclusion would drop to 20 from 25 years. Equal weighting results in a smaller average market cap than the S&P 500 but also a contrarian rebalancing strategy at each quarterly rebalance. Equal weighting forces the fund to sell recent winners and buy recent losers at each rebalance. According to Morningstar, stocks in the fund have a long-term earnings growth forecast of 8.8%, a historical growth rate of 1.8% and a return on invested capital of 14.8%. Stocks in the fund recently had a yield of 2.6%, gross of the fund's 0.35% expense ratio.
PowerShares Dividend Achievers ETF (NASDAQ:PFM)
PFM follows the Nasdaq US Broad Dividend Achievers Index, which tracks stocks that have increased dividends for at least ten consecutive years. Compared to NOBL, PFM does not require as long of a track record of dividend increases and it also does not require that its holdings be constituents of the S&P 500. The fund recently held 274 holdings and the top five are Microsoft, Johnson & Johnson, Exxon Mobil (NYSE:XOM), AT&T (NYSE:T), Procter & Gamble. Constituents are weighted by market cap. According to Morningstar, stocks in the fund have a long-term earnings growth forecast of 7.3%, a historical growth rate of negative 1.6% and a return on invested capital of 13.2%. Stocks in the fund recently had a yield of 2.9%. At 0.55%, the fund's expense ratio is the highest among the five ETFs mentioned here and eats into the fund's yield. In addition, it is more expensive to trade, with wider bid-ask spreads and lighter trading volumes.
Vanguard Dividend Appreciation ETF (NYSEARCA:VIG)
VIG follows the Nasdaq Dividend Achievers Select Index, which is similar to the Broad Dividend Achievers Index but it eliminates stocks that do not pay qualified dividends (mostly REITs and MLPs) and applies some proprietary screens to weed out stock with poor dividend sustainability. Qualified dividends are those that may qualify for the lower long-term capital gains treatment rather than the higher ordinary income tax rate. Although not disclosed, the proprietary screen can have a big impact. Of the top 20 holdings in PFM, only 11 are also in VIG. The differences in methodology appear to have helped VIG. During the past ten years through July 2016, VIG returned 7.8% compared to 6.1% for PFM. Eliminating stocks that do not pay qualified dividends and after applying its proprietary screens, the number of holdings in VIG is 185, down from 274 in PFM. The top five stocks are Microsoft, Johnson & Johnson, Pepsi (NYSE:PEP), Coca-Cola, Medtronic (NYSE:MDT). According to Morningstar, stocks in the fund have a long-term earnings growth forecast of 9.1%, a historical growth rate of 4.0% and a return on invested capital of 15.5%. Stocks in the fund recently had a yield of 2.3%. That yield is lower than the yield on PFM in part due to the exclusion of REITs and MLPs. The expense ratio is rock-bottom at just 0.09%.
Looking at this historical record, dividend payers have outperformed non-payers. But it is not the highest yielding stocks that produce the best performance. Companies that offer dividend growth combined with lower dividend payouts seem to offer better returns. We previously highlighted five of the best dividend ETFs, but most of those tilt heavily toward value. Dividend ETF investors don't have to tilt toward value stocks. Instead, they can look at the ETFs mentioned here to find quality dividend growth. While each of these five ETFs attempt to offer dividend growth, DGRW uses a unique approach. Rather than looking at historical dividend growth, it looks for stocks with strong returns on capital that are forecast to have strong growth in the future.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.