Dividend ETFs: Don't Bank On Stable Dividends

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Includes: FDL, VIG, VYM
by: 4D Investments

Summary

The dividend payments of dividend-seeking exchange-traded funds are surprisingly unstable.

Huge dividend cuts during 2008-2009 combined with unstable dividend payments are causes for concern for dividend-seeking investors.

We identify the best and worst performers.

Many dividend-seeking investors will have the objective of building a portfolio of companies that provide a stable and growing dividend stream. We explore whether dividend-seeking exchange-traded funds ("ETFs") can provide a simple solution for investors that don't have the time to analyze companies and build their own portfolios.

We have written previously about the various strategies followed by dividend-focused ETFs and how that influenced their performance; we now extend that analysis with a focus on the stability of the dividend streams and the ability of the ETFs to maintain their dividends during tough economic times such as the financial crisis of 2008-2009. Our universe covered U.S. dividend-seeking ETFs in existence for at least 10 years and with a current minimum size of $800 million.

Dividend ETF: Unstable dividend payments and huge declines in 2008-09

A word on ETF dividend payments

ETFs pay dividends from the income that they receive from the companies held in their portfolios. In addition, many ETFs also generate income from interest on cash balances and from securities lending. This may be small in relation to the dividend income and is normally indicated as non-qualified income when paid out as a dividend to ETF unitholders. We count both these type of payments as dividend payments received in the hands of the ETF unitholders.

ETFs also from time to time pay out short- and long-term capital gains generated from their investing and trading activities. We don't consider this as normal or sustainable income and exclude this from our dividend assessments.

Unstable dividend track records

The table indicates a shortlist of popular U.S. dividend-seeking ETFs that have track records of 10 years or longer. The Vanguard Total U.S. Market ETF is used as an overall benchmark.

Some comments:

  • Dividend payment declines from peak to bottom ("Div Max drawdowns"), 7 of the dividend ETFs were more than 30%. This would have made a huge dent in the income of investors that depend on dividend income (see graph). Of course, these declines happened during a severe economic contraction in 2008-2009 but the extent of the declines was most disappointing, especially for specialist dividend funds.
  • Only 2 of the ETFs (VIG and FVD) had smaller dividend declines in 2008-2009 than the overall market ETF (VTI).
  • All the dividend ETFs had a higher incidence of rolling 1-year dividend declines that the overall market ETF.
  • A particularly poor performer was FDL with dividends declining in 36% of the rolling 1-year period.
  • Only 2 of the ETFs (VIG and VOE) had higher dividend growth over the past 10 years than the overall market ETF, VTI. Notably, these are also the ETFs that select companies for their ability to grow dividends.
  • All the dividend ETFs except 2 (FVD and SDY) had higher volatility in their rolling 1-year dividend payments than the market ETF. Particularly, volatile was DTN, FDL, and VOE.
  • Low dividend growth over 10 years was recorded by SDY, FDL, and DVY. Particularly concerning was the lack of dividend growth recorded by FDL and DVY which also had huge dividend declines ten years ago.

This is a disappointing overall performance from many of these popular dividend-focused ETFs. Not only did the market ETF, VTI, beat most of the dividend ETFs over the past 10 years from a total return perspective, but it also performed better regarding dividend growth and stability.

One to avoid

First Trust Morningstar Dividend Leaders ETF invests in U.S. companies, excluding real estate investment trusts, that have a consistent record of paying and growing their dividends. The ETF tracks the Morningstar Dividend Leaders Index.

The Dividend Leader Index selects the 100 highest yielding stocks from a universe of stocks identified by a Morningstar proprietary screening process. Index constituents are weighed according to their market capitalization, free float, and annual dividend per share. Weights are capped, and the portfolio is rebalanced once a quarter.

The ETF holds a diversified portfolio of 100, mainly large-cap stocks; the top 10 represent 54.9% of the portfolio's assets. Still, the portfolio includes large holdings in Exxon Mobil (NYSE:XOM) (8.8%), AT&T (NYSE:T) (7.7%), Verizon Communications (NYSE:VZ) (6.8%), Pfizer (NYSE:PFE) (5.9%), Chevron (NYSE:CVX) (5.1%), Procter & Gamble (NYSE:PG) (5.1%), Philip Morris (NYSE:PM) (4.3%), and Coca-Cola (NYSE:KO) (3.9%).

The largest sector allocations are to consumer defensives (25%), energy (15%), communication services (15%), utilities (14%), and healthcare (13%).

The ETF launched in March 2006 and has built a reasonable performance track record. Over the past 10 years, the ETF delivered a total return of 167% compared to the 184% of the Vanguard Total Market ETF.

This is a fairly large fund with $1.4 billion of assets. The ETF charges an expense ratio of 0.45%; there are lower cost dividend ETFs available.

The fund pays a fluctuating quarterly dividend; over the past 12 months, the total dividend amounted to $1.02 for a yield of 3.41%. Dividend payments from the ETF were surprisingly volatile, given the high-quality portfolio. The maximum dividend decline experienced over the past 10 years was 38% compared to the 20% decline of the overall market ETF (VTI).

Equally concerning was the fact that the ETF had very inconsistent dividend payments - evidenced by the 36% of rolling 1-year dividend payments that were lower than the dividend payment 1-year earlier. This was the worst performance of all the ETFs listed. In addition, dividend growth over the past 10 years was only 12% or 1.2% per year on average - below the rate of inflation.

For investors looking for consistent dividend payments and growth, this is one to avoid.

Two to consider

Vanguard Dividend Appreciation ETF (VIG) invests in U.S. companies that have a record of increasing dividends for at least the past 10 years and pass certain (undisclosed) screens for profitability. The fund selects stocks from the Nasdaq U.S. Broad Dividend Achievers Index, excluding real estate investment trusts and limited partnerships. Stocks that pass the selection screens are weighed by their market capitalization, but individual weights are capped at 4%.

The ETF currently holds 182 stocks with the top 10 representing 31% of the portfolio's assets. The largest sector allocations are to industrials (29%), consumer cyclical (18%), consumer defensives (10%), healthcare (10%), technology (9%) and financials (8%).

This is a widely diversified portfolio of mostly large-cap stocks. The main stock holdings include Microsoft Corp. (NASDAQ:MSFT) (4.4%), Johnson & Johnson (NYSE:JNJ) (3.9%), Walmart (NYSE:WMT) (3.8%), PepsiCo (NYSE:PEP) (3.5%), 3M Co. (NYSE:MMM) (2.7%), McDonald's Corp. (NYSE:MCD) (2.7%), Medtronic (NYSE:MDT) (2.6%), Union Pacific Corp. (NYSE:UNP) (2.5%), and Abbott Laboratories (NYSE:ABT) (2.5%).

The ETF launched in April 2006 and has built a reasonable performance track record. Over the past 10 years, the ETF delivered a total return of 164% compared to the 184% of the broader market index. Over the past 5 and 3 years, the performance was only slightly behind the broad market and better than most of its dividend-seeking ETF peers.

The ETF has one of the lowest ETF expense ratios of 0.08%; this helps its performance relative to the more expensive peers. This is the largest of the dividend ETFs with $30.1 billion of assets.

The fund pays a fluctuating quarterly dividend; over the past 12 months, the total dividend amounted to $1.94 for a yield of 1.73%. Over the past 10 years, the dividend payments of the ETF units increased by 94% and by 33% over the past 5 years. Dividend payments dropped by a relatively modest 14% during the financial crisis. In addition, rolling 1-year dividends only declined 17% of the time over the past 10 years.

Vanguard High Dividend Yield ETF (VYM) invests in U.S. companies that pay dividends. The fund tracks the FTSE High Dividend Yield Index which selects the highest yielding U.S. dividend-paying stocks from the FTSE All-World Index. This index excludes real estate investment trusts. Selected stocks are weighted by their market capitalization.

The ETF currently holds 403, mainly large-cap stocks with the top 10 representing 26.4% of the portfolio's assets. The largest sector allocations are to financial services (17%), healthcare (14%), consumer defensives (13%), technology (11%), industrials (12%), energy (10%), and utilities (7%).

This is a well-diversified portfolio with relatively small exposures to individual companies. The main stock holdings include JP Morgan (3.8%), Johnson & Johnson (3.5%), Exxon Mobil (3.3%), Wells Fargo (NYSE:WFC) (2.5%), Pfizer (2.3%), AT&T (2.3%), Cisco (NASDAQ:CSCO) (2.2%), and Intel (NASDAQ:INTC) (2.2%).

This is a large fund with $22 billion of assets and a low expense ratio of 0.10%.

The ETF launched in November 2006; over the past 10 years, the ETF delivered a total return of 169% compared to the 184% of the Vanguard Total Market ETF. Over the past 3 years, the performance was only slightly behind the broad market.

The fund pays a fluctuating quarterly dividend; over the past 12 months, the total dividend amounted to $2.48 for a yield of 2.8%. Over the past 10 years, the dividend payments of the ETF units increased by 62%, well ahead of the rate of inflation.

During the financial crisis, the dividend dropped by 31% which was in line with the average of the dividend ETFs. Rolling 1-year dividend declines also occurred 19% of the time, which is one of the better track records among the dividend ETFs.

We are not impressed by the dividend-paying track records of the 10 popular dividend-seeking ETFs listed in the table. Their dividends declined substantially during the financial crisis of 2008-09 and generally had rather inconsistent dividend payments.

Our top 2 selections for stable dividends should do a reasonable job for dividend-seeking income investors. The VIG has a low dividend yield of only 1.74% but a track record of consistent and fast-growing dividends. The VYM has a higher initial yield of 2.8% but that comes with lower growth and somewhat less dividend consistency.

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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.