DGRO: Here's Why This Is Our Top-Pick Among Dividend Growth ETFs

Summary

• DGRO tracks a basket of U.S. stocks with at least 5 consecutive years of dividend growth.
• DGRO has outperformed not only a peer group of comparable dividend growth ETFs in recent years but also the S&P 500 since inception.
• This is our top pick in the dividend growth ETF segment but we take a cautious view given significant uncertainty surrounding ongoing coronavirus outbreak and global growth outlook.

The iShares Core Dividend Growth ETF (NYSE:NYSEARCA:DGRO) with $10.6 billion in total assets is designed to track a basket of U.S. stocks with a dividend growth profile. The fund has an expense ratio of 0.08% making it a good low-cost option to gain exposure to a group of high-quality stocks that are typically leaders in their industries. We highlight that DRGO has outperformed the S&P 500 (SPY) since inception while offering a higher dividend yield which adds to its attraction as a potential core-holding built around a fundamental strategy. This article covers why DGRO is our top-pick in the 'dividend-growth' ETF category considering its strong performance history and what we see is a superior strategy.

(source: Finviz.com)

DGRO Background

DGRO tracks the 'Morningstar US Dividend Growth Index' which only includes stocks that have at least a 5-year history of increasing the dividend payout. There is also an additional screening criterion focusing on dividend sustainability.

• The index requires companies to pay no more than 75% of earnings on average. The effect here is to exclude companies that may not be able to continue with dividend growth or is facing financial weakness. This rule also excludes real estate investment trusts and other types of corporate structures that typically pay upwards of 100% of earnings.
• Separately, companies in the top decile based on dividend yield are also excluded. This rule serves to limit exposure to companies with excessively high yields that may be a sign of poor stock price performance or otherwise weak growth income vehicles.

The result of these screening functions leads to a basket of high-quality and fundamentally strong companies that are then weighted by market capitalization. The current portfolio of 478 holdings is otherwise well-diversified across sectors with a tilt towards large-cap value.

Dividend Growth ETF Comparables

There are a couple of notable comparable dividend growth exchange-traded funds including the Vanguard Dividend Appreciation ETF (VIG) and the WisdomTree U.S. Dividend Growth ETF (DGRW), SPDR S&P 500 Dividend ETF (SDY) and the ProShares S&P 500 Div. Aristocrats ETF (NOBL).

Given the focus on "dividend growth", it's worth noting that DGRO's calendar year 2019 total distribution of $0.93 per share was up 14.8% compared to $0.81 in 2018. This was the highest in the group compared to 12.9% for DGRW, 8.2% for SDY, 4.7% by VIG, and a tepid 1.6% by NOBL. For reference, the S&P 500 Trust ETF (SPY) dividend payout in 2019 was up 9.3%.

(source: data by YCharts/ table by author)

Our explanation is that DGRO is unique as it only requires a 5-year history of dividend growth for a stock to be included. This method typically captures more companies that initiated the dividend more recently. In contrast, NOBL's strategy based on investing in "dividend aristocrats" which are companies that have a 25-year history of increasing its dividend, and VIG requiring a 10-year history includes more low dividend growers. SDY falls to the same weakness as it is based on stocks with a 20-year dividend growth history within the S&P 500. WisdomTree's DGRW for its part inclusion criteria is based more on fundamental growth factors and does not have a history requirement.

Apple Inc (AAPL) which initiated its dividend in 2012, highlights the implications to the particular dividend growth ETF methodologies. Coincidently, AAPL which represents 3.4% in DGRO has boosted the ETF performance given the stock climbed by 89% in 2019. AAPL is not a constituent of either VIG, NOBL, or SDY.

(source: data by YCharts/ image composite by author)

From the data above we also see that VIG and DGRW are more concentrated among top holdings as the largest stocks represent more than 5% of the fund compared to 3.4% in DGRO's largest position. DGRO is also the largest fund with 478 holdings compared to 187 stocks in VIG and 300 in DGRW. The wider diversification in DGRO is a positive in the fund's profile.

Performance

DGRO has impressively outperformed not only the other dividend ETFs since its inception but also the S&P 500 over the period. Since June of 2014, DGRO is up a cumulative 84.4% on a total return basis compared to 79.9% for SPY, 79.4% for DGRW, 76.2% for VIG, and a more modest 74.6% for NOBL.

(source: data by YCharts/table by author)

In terms of performance on a total return basis, DGRO has slightly underperformed VIG over the past 3-years and marginally below DGRW over the past 6-months. As it relates to VIG, the performance spread here is related to the particular timing period.

Dividend Yields

The other consideration here is each fund's weighting methodology. While VIG features a more traditional "modified market cap-weighted" tracking index methodology, DGRO and DGRWs are based on a dividend-weighted concept, essentially the aggregate value of each stock's annual dividend payout in Dollar terms. NOBL is an equal-weighted fund. SDY is based on dividend yield weighted which supports a yield advantage to the group currently at 2.58%. On the other hand, DGRO with a dividend yield of 2.32% is above VIG which yields 1.74%, DGRW at 2.11%, and NOBL at 1.89%

Analysis and Forward-Looking Commentary

The current development in the market is a historic level of volatility and uncertainty associated with the emergence of the COVID-19 outbreak and its implications for global growth. Our concern here is that beyond the public health crisis that should eventually be contained, the economic impact may be deeper and longer-lasting.

The process of resetting expectations takes time and the setup here is that risks are tilted to the downside. The risk is that a turn in global business confidence and consumer sentiment may lead to a self-fulfilling recessionary environment that policymakers are unable to revive simply through monetary policy.

The dividend ETFs may represent only limited protection and we can use the data from Q4 2018 to see how these funds traded during a market stress environment. During the period in 2018, the stock market approached a bear-market territory with the S&P 500 briefly trading down 20% from its highs. We note that DGRO fell by 17.6% as its max drawdown in 2018 which was better than the 18.1% loss in VIG and 19.5% decline in DGRW. The fund's current 3-year beta at 0.93 is consistent with the trading history over this period. We expect DGRO to move lower with the market but with slightly reduced volatility.

Based on our more cautious view of the market and equities in general, we think investors should hold off on picking DGRO up or adding to a position. We see the ETF price around $36 per share as representing a level of support and potentially more compelling buying opportunity if it trades there. The risk that the global growth outlook deteriorates and or the coronavirus epidemic intensifies could lead to a more extended downside.

Takeaway

Recognizing that DGRO is not necessarily meant to "beat" the market, as a passive ETF with a focused strategy, the fund performs well. Each of the funds discussed above has some favorable attributes and excel in certain areas. Investors can have their own preference but we think DGRO is the best choice as a core holding within a diversified portfolio.

We'd think VIG's requirement of a 10-year dividend growth history represents a weakness as its an unnecessary limitation that excludes otherwise quality stocks. DGRW has an interesting strategy similar to DGRO but its higher expense ratio at 0.28% appears unnecessary.

The Dividend Aristocrat ETF has the highest expense ratio in the group and also some of the weakest performance and dividend growth. While a 25-year history of increasing the dividend rate is impressive at a company level, the passive strategy in an ETF does not appear to generate excess returns. SDY has the highest dividend yield, but in our opinion, the advantage is not enough to balance its weaker performance history. We also think SDY's expense ratio at 0.35% is a weakness in its profile.

What we like about DGRO is that it is the most well rounded across the various metrics we are looking at. We think the fund's particular methodology of only requiring a 5-year dividend growth history represents a level of flexibility and forward-thinking that is better to capture current market trends. The combination of strong returns history, relatively high yield at 2.34% and low expense ratio at 0.08% make DGRO our top-pick in the "dividend growth ETF" segment. Take a look at the fund's prospectus for a full list of risks and disclosures.

Analyst’s 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.