The iShares Core Dividend Growth ETF: Here's How It's Kept Pace With The S&P 500

Summary

• DGRO has managed to keep pace with the S&P 500 since its 2014 inception, which is no small feat considering the fund's strong large-cap value lean.
• This article analyzes how DGRO has been able to behave like an ETF with a 1/3 growth allocation despite it having only a 6% overlap with Morningstar's Large-Cap Growth Index.
• The answer is in Morningstar's screening criteria, which avoids chasing yield and instead focuses on dividend growth and sustainability.
• The result is a dividend growth-focused ETF that performs well during bull markets, and could possibly outrun the S&P 500 if the highest-yielding dividend stocks fall out of favor.

Investment Thesis

I'm often critical of dividend ETFs that seem to put yield first while ignoring total returns, but it's hard to find this fault with the iShares Core Dividend Growth ETF (NYSEARCA:DGRO). Since its inception nearly seven years ago, its returns have kept pace with the S&P 500. It has produced higher than average portfolio income and notably done so even while maintaining a large-cap value lean. This article will explore how DGRO has been able to do it and offer lessons to value and dividend investors alike about what to look for when searching for a core ETF you can hold in both bull and bear markets.

ETF Profile, Methodology

DGRO samples the Morningstar U.S. Dividend Growth Index, which consists of about 400 U.S. securities that pay qualified dividends, have five years of uninterrupted annual dividend growth and have estimated payout ratios less than 75%. It's a dividend dollar-weighted index unique to others that weight based on yield or market capitalization. This method allows it to achieve broad diversification across industries. There is also a nod to the importance of shareholder yield. The index will not exclude companies executing share repurchases even if they fail to raise dividends the previous year.

A key feature of the Index is that it excludes securities yielding in the top 10% of the Morningstar U.S. Market Index. Don't underestimate the value of this screen. As I will show later, this segment of dividend-paying companies averages among the worst-performing U.S. stocks over the last two decades. By getting them out of the way to start, DGRO has a substantial long-term advantage over other ETFs.

The fees are also attractive at only 0.08% annually. Its yield of 2.38% may be considered low for a dividend-focused fund, but it is still almost a whole percentage point higher than S&P 500 ETFs. More importantly, it has grown every year since its inception in 2014, with double-digit growth figures coming in each of the last three years.

Source: Seeking Alpha

DGRO is currently heavy into Financials, Information Technology, Health Care, and Industrials, which total nearly 70% of the fund. Defensive sectors such as Consumer Staples and Utilities make up a smaller portion. Energy is notably absent due to the screening requirement of at least five years of uninterrupted dividend growth. Given the current environment, investors should not expect this to change for many years. If this is problematic for your long-term strategy, consider individual securities or targeted sector ETFs to supplement this holding.

Source: iShares DGRO Fund Profile

DGRO's top ten holdings make up 25.68% of the fund, compared to 26.68% for the S&P 500 Index ETF. It isn't much of a difference, but for those concerned about the valuations of Apple (AAPL), Microsoft (MSFT), and Amazon (AMZN), you may find DGRO to be a bit better balanced.

Source: iShares DGRO Fund Profile

DGRO Performance Since Inception

DGRO has similar historical risk and returns to the S&P 500. Since July 2014, its CAGR of 11.93%, the standard deviation of 13.76%, and Sharpe Ratio of 0.83 are almost identical to the iShares Core S&P 500 ETF (IVV).

Source: Portfolio Visualizer

Short-term, DGRO's underperformance can be traced to the last year, where its 23.57% return has trailed IVV's 31.53%. However, as shown below, portfolio income is consistently higher than IVV, and the gap is widening.

Source: Portfolio Visualizer

Holdings-Based Style Analysis

What is most impressive about DGRO isn't just that it's been able to keep pace with the S&P 500, but it has done so with a significant large-cap value lean. I ran a holdings-based style analysis in Portfolio Visualizer, which attempts to explain a portfolio's returns by asset class allocation. The results were approximately 66% U.S. Large-Cap Value and 34% U.S. Large-Cap Growth. Comparing DGRO to the returns of an index ETF portfolio of these two asset classes, we can see that it's a very accurate representation.

Source: Portfolio Visualizer

Looking at Morningstar, however, paints a different picture. Placed in the Large Value category, the fund scores 81.95 on its value style. By comparison, a blended fund like IVV scored 52.35, while a growth fund like Vanguard's Growth ETF (VUG) scored 10.16.

As further evidence of the fund's value lean, consider its overlap with ETFs that track Morningstar's U.S. Large-Cap Growth and Value Indexes. There is only a 6% overlap with the Growth ETF (JKE) but a 49% with the Value ETF (JKF). The rest, presumably, are large-cap blend stocks.

Source: ETF Research Center

The question now is how DGRO has managed to emulate a portfolio that is approximately 1/3 U.S. large-cap growth while having such a small allocation to actual U.S. growth stocks. To find the answer, let's return to the first step in Morningstar's methodology, which screens out the top 10% of dividend-yielding stocks.

The Highest-Yielding Stocks Have Underperformed Since DGRO's Inception

The Fama-French Forum on the Dartmouth College Website provides a wealth of information on various model portfolios' historical returns. Below is a summary of the average annualized returns by dividend yield. Decile 1, for example, represents the average annualized return of the top-yielding stocks, which DGRO would exclude.

Source: Created By Author Using Data From Fama / French Portfolios Formed On Dividend Yield (Dartmouth College)

Over the last 20 years, excluding the top-yielding stocks proved beneficial most, but not all of the time. The most recent exception was 2020 when the highest-yielding stocks returned 13.80% on average compared to 10.16% for non-dividend-paying stocks (Decile 10). Also, of note, both the highest-yielding stocks and non-dividend-paying stocks produced the two lowest average annual returns since 2001 (12.43% and 11.41%, respectively). A strategy that avoids both of these segments is preferable, and that is what DGRO follows.

A more appropriate way of analyzing this data set is by comparing the returns of stocks in Decile 1 with the average returns of stocks in Decile 2 through 9. Below is a graph summarizing these results.

Source: Created By Author Using Data From Fama / French Portfolios Formed On Dividend Yield (Dartmouth College)

As you can see, excluding the top 10% of dividend stocks has been advantageous for every year since DGRO's inception. The notable exception was 2020, when the top dividend stocks returned 13.80% on average compared to 7.08% for the remainder. It's no coincidence either that 2020 was a significant year of underperformance for DGRO and that this initial screen was a drag for the fund.

Also, had the fund started before 2014, the results would likely be less impressive. 2009, 2011, and 2013 saw the top dividend-paying stocks materially outperforming other dividend stocks by 12.94%, 8.02%, and 6.02%, respectively.

Of course, a valid concern is if the 2020 trend continues where the highest dividend-yielding stocks outperform the most and DGRO cannot capture those returns. If this happens, this will likely mean the market has switched away from large-cap growth stocks and moved into value territory. While DGRO may underperform other dividend growth ETFs, I think it will continue to be competitive with the S&P 500 because of its strong lean on value stocks. For this reason, DGRO makes for an excellent core holding regardless of whether value or growth is favored.

Investment Recommendation

I've reviewed numerous dividend ETFs over the last few months, and DGRO is my favorite to date. First, the fund is slightly more diversified than the S&P 500, with its dividend-dollar-weighted methodology being the primary reason why stocks such as Apple, Microsoft, and Amazon have less exposure. DGRO would hold an advantage if these high-valued stocks were to fall out of favor. I also feel confident knowing that even if growth stocks outperform, DGRO performs as though it has 1/3 growth exposure. Second, I prefer a fund that does not chase yield, and Morningstar's methodology immediately screens the top 10% yielding stocks out. History shows that the top and bottom-yielding stocks produce the worst average returns over the long run, so it makes sense to invest in a fund that subscribes to this same philosophy. The best returns lie somewhere in the middle, and DGRO's 2.38% yield appears to hit that sweet spot. It's focused on dividend growth, not yield, and therefore avoids most of the yield traps investors often fall into.

The fund is not without faults, of course. Earlier, I noted how DGRO does not have any Energy exposure and likely will not for years to come. This may be a source of underperformance if recent oil forecasts prove correct, such as Goldman Sachs' prediction of $72 WTI by Q3. While I was bullish on the sector to end the year, I understand the need for dividend sustainability, and frankly, avoiding this sector may ultimately prove to be a positive thing. The fund also lacks any Real Estate exposure due to its screening out of securities that do not meet the IRS' definition of qualified income. It's a gap, but one that's easily filled with various sector ETFs such as the Vanguard Real Estate Fund (VNQ) or the Real Estate Select Sector SPDR Fund (XLRE).

Overall, I think it's an excellent choice for investors due to its focus on dividend growth, its not-too-high dividend yield, its avoidance of yield traps, and its low fees. I expect solid performance for years to come and think it qualifies as a core holding in any dividend portfolio.

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.