TDIV: Where Technology Meets Dividends

by on October 18, 2012 | ETFs Mentioned:

With countless investors shifting assets to dividend-paying securities in lieu of chasing after capital gains amid the current low-rate environment, it appears that many have entirely devoted their efforts to finding attractive sources of yield. Luckily, the ETF universe is vast and investors have options when it comes to generating current income; one particularly innovative fund from First Trust bridges the gap between capital gains and dividends, allowing investors to enjoy the best of both worlds. Ryan Issakainen, Senior Vice President and ETF strategist at First Trust, recently took time to discuss the NASDAQ Technology Dividend Index Fund (TDIV), shedding insights on the unique strategy powering this ETF [see also Monthly Dividend ETFdb Portfolio].

ETF Database (ETFdb): What was the inspiration behind creating the NASDAQ Technology Dividend Index Fund (TDIV)?

Ryan Issakainen (RI): The idea for the ETF originally sprang from a conversation that one of our institutional consultants had with a wealth manager in San Francisco called Baker Avenue Asset Management. We recognized that the trend of technology companies both introducing new dividend policies, and increasing payments in existing dividend policies, was “building steam”, and this is a trend we expect to continue. We also recognized that most equity income ETFs are not only underweight technology stocks today, but will likely remain so for quite some time, due to their respective index methodologies. So we view TDIV as a useful complement to those equity income portfolios.

ETFdb: Why have technology stocks avoided paying dividends in the past?  What evidence suggests that this trend is reversing?

RI: Over the past two decades, many technology companies have chosen to reinvest their earnings in pursuit of future growth opportunities, rather than making regular dividend payments to investors. In effect, investors in these companies agreed to forego current dividend payments in exchange for potential capital appreciation, as well as potentially larger dividends in the future. In many cases, this trade-off has worked out well for investors. For example, in 2002, when Apple had a market capitalization totaling about $5.3 billion, the company paid no dividends. Instead, envisioning future growth opportunities, Apple invested heavily to develop new technologies. A decade later, and with a market capitalization of over $600 billion, Apple began implementing a new dividend policy in 2012, intending to pay out about $10 billion in dividends to investors over the course of its first year. Long-term investors in Apple, and many other technology companies, have been well compensated for their patience [see also High Tech ETFdb Portfolio].

Today, there are still certain segments of the technology sector, such as cloud computing, that are poised for growth rates well in excess of the overall technology sector, not to mention the broader economy. Such companies pursue the best interests of their investors by reinvesting heavily to fuel future growth. These companies are less likely to pay dividends. However, there are also a growing number of technology companies that have reached a point of maturity wherein a smaller percentage of earnings is required to fuel future growth opportunities. For many of these companies, we believe the implementation of a dividend policy represents sound corporate governance, as well as management’s confidence in the consistency of future earnings. While some fret over the potential for slower earnings growth that sometimes accompanies the implementation of a dividend policy, others consider the many benefits that often accrue to more mature companies, such as a lower cost of capital and generally less volatile earnings.

As recently as 2007, the information technology sector contributed just under 6% to the aggregate dividends paid out by companies in the S&P 500 Index, representing the third lowest contribution of any sector. In a dramatic reversal, by mid-August 2012 the information technology sector made the largest dividend contribution of any sector, representing over 14% of the index’s total dividends. This was achieved as dividend payments from the information technology sector grew in each of the last 5 years (ending on 8/31/12), at an 18.8% average annual rate, while dividends from the S&P 500 grew in only 3 of the last 5 years, resulting in a 1.6% average annual growth rate.

Not only has the technology sector offered a robust rate of dividend growth in recent years, we believe many of these companies are well positioned to further increase dividends in the years ahead. In fact, as of 10/11/12, the free cash flow yield for the NASDAQ Technology Dividend Index is about 8.6%, nearly three times its 3.1% dividend yield. This implies that index constituents generally have plenty of room to increase dividends without necessarily reducing current investments in future growth opportunities or drawing cash from their balance sheets.

ETFdb: Why does it make sense to use the ETF wrapper for investors looking to pursue this sort of strategy?

RI: The ETF is a great vehicle for delivering low cost, liquid, and transparent exposure to a strategy like TDIV, and it also benefits from the more tax-efficient structure of ETFs versus traditional mutual funds.

ETFdb: How might TDIV fit into a portfolio? Would you consider this as a core, or more tactical holding?

RI: Despite the recent trend of technology companies choosing to reward shareholders with increased dividends, equity income ETFs remain dramatically underweight technology stocks. For example, the five largest equity income ETFs, which represent over $38.5 billion in assets, are underweight the technology sector by an average of 15 percentage points, as compared to the S&P 500. Not surprisingly, the same five ETFs are overweight the utilities sector by an average of 10 percentage points, and overweight the consumer staples sector by an average of 9 percentage points.

Moreover, most equity income ETFs will likely remain underweight technology stocks for many years to come, due to certain dividend longevity requirements included in their respective index methodologies. For example, the S&P 500 Dividend Aristocrats Index requires companies to have followed a policy of increasing dividends every year for at least 25 consecutive years. This implies that a company like Apple, which initiated a new dividend policy in 2012, will not be eligible for inclusion until 2037!

Generally speaking, we view TDIV as an attractive vehicle for investors to gain exposure to some of the more stable, dividend-paying stocks in the technology sector; but we also believe the fund may provide a useful complement to equity income strategies that are underweight technology stocks, and overweight defensive sectors, such as utilities and consumer staples. In such instances, the addition of technology stocks may enhance a portfolio’s diversification, while potentially increasing its anticipated rate of dividend growth.

ETFdb: Broadly speaking, what trends are you seeing in the technology sector?

RI: As the landscape of dividend-payers evolves, we expect the trend of technology stocks initiating and raising dividends to continue, providing investors with a new source of equity income, with the potential for above average growth.

Bottom Line: The technology sector is more often than not praised for its lucrative growth potential, with little or no attention directed to its income-generating potential. This misconception is fading away however as well-known companies from this corner of the market are adopting dividend policies in addition to posting impressive distribution growth rates. As such, the NASDAQ Technology Dividend Index Fund from First Trust presents itself as a viable tool for investors looking to maintain exposure to this high-growth market segment without sacrificing current income.

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Disclosure: No positions at time of writing.