Despite any pending actions by the Federal Reserve with regards to interest rates, dividends still matter to investors. After all, these steady and increasing payouts are one of the main generators of stock market total returns over the long haul. Reinvesting those dividends provides an added boost and allows for compounding to happen faster.
But newer studies have shown that not just any dividend payout will do.
Most dividend-focused indexes rank their stocks solely by yield. That’s a problem as a high yield – after kicking out pass-through entities like REITs and MLPS — can indicate some big company-specific issues. By focusing only on the headline number, investors may be doing their portfolios a disservice.
It’s here that the concept of “quality dividends” is born.
By looking at metrics such as profitability, sales growth, cash flows, dividend growth, payment histories and more, new smart-beta ETF providers are hoping to craft better dividend indexes that will circumvent these issues. Investors are able to get the cream of the crop with regards to dividends, and in turn get better risk-adjusted and higher returns.
There are now plenty of options for investors to add quality dividends to their portfolios. Let’s take a look at three: the O’Shares FTSE US Quality Dividend ETF (OUSA ), FlexShares Quality Dividend Defensive ETF (QDEF ) and iShares MSCI USA Quality Factor ETF (QUAL ) and see what makes them tick.
While Kevin O’Leary is more famous for his role on the hit TV show Shark Tank, the serial entrepreneur is a wealth manager first. That led to the creation of the O’Shares line of ETFs. OUSA tracks the FTSE US Quality/Volatility/Yield Factor 5% Capped Index, which is a measure of large- and mid-cap dividend-paying stocks domiciled in the United States. FTSE screens for various liquidity, high-quality, low-volatility and dividend yield requirements. The various high-quality and low-volatility requirements are designed to reduce exposure to high yielding dividend equities that have experienced large price declines. Basically, OUSA is attempting to limit the “high yield equals troubled firms” phenomenon.
OUSA holds over 140 different stocks. Consumer staples (17.50%), health care (17.1%) and technology (13.9%) make up the largest sector weightings. Top holdings read like a who’s who of America’s top stocks, with names like Johnson & Johnson (JNJ), Exxon (XOM) and Apple (AAPL) rounding out the main holdings of the ETF (as of 9/2/2015). The index and fund rebalance quarterly .
Expenses for OUSA are fairly cheap at 0.48% or $48 per $10,000 invested.
Unbeknownst to many investors, asset manager Northern Trust is actually one of the largest index sponsors around. That includes creating some of the world’s first smart-beta indexes long before it was “cool.” Today, that knowledge extends itself to its FlexShares line of ETFs and QDEF.
QDEF first looks at stocks within the very broad Northern Trust 1250 Index. As with most smart-beta ETFS, QDEF will use various fundamental factors including profitability, solid management, and reliable cash flows to create its portfolio of quality dividend stocks. The kicker comes in regards to the “defensive” part of its name. QDEF will add a volatility screen to its portfolio. By doing this, QDEF’s holdings will bounce around less than the “quality only” version of its index, in this case, the FlexShares Quality Dividend ETF (QDF ).
QDEF holds roughly 187 different stocks. Financials (19.34%), technology (16.26%) and consumer discretionary names (12.34%) make up the top three sector weightings. QDEF is clearly a value ETF as more than 56% of the portfolio’s holdings meet this style, with only about 8% counting as growth stocks. The portfolio is also dominated by large-cap stocks, with only around 20% in small- and mid-caps (as of 9/2/2015).
Expenses run at 0.37% for the ETF.
As one of the largest ETF issuers, iShares has gotten into the smart-beta trend in a big way. QUAL was one of the first bespoke ETFs, created specifically for the Arizona Pension System. And while QUAL isn’t specifically dividend focused, it does fit very much in the quality dividend ETF camp.
QUAL recently underwent a change to its tracking index and now follows the MSCI USA Sector Neutral Quality Index. However, the basic screens are the same. QUAL will look for large- and mid-cap stocks that have high returns on equity, stable year-over-year earnings growth, and operate under low financial leverage. That’s a fancy way of saying they don’t have a lot of debt.
What’s interesting is that these screens basically produce a portfolio of 125 quality dividend payers. And the ones that don’t pay anything, like Berkshire Hathaway (BRK.B), could, based on their financials. Tech (20%), financials (16.26%) and health care (13.28%) make up the top sector weights in QUAL’s portfolio.
Expenses run a dirt cheap 0.15%.
How to Use Them
While OUSA, QUAL and QDEF are similar in that they focus on quality and yield, they are vastly different ETFs and could have different uses depending on your situation.
For example, if you’re worried about the recent bouts of volatility and the potential for an economic downturn — say, like what’s happening in the markets now — then QDEF should do better than OUSA or QUAL as they don’t account for any “defensiveness.” Ultimately, the difference in how QDEF accounts for that in its screens should help if the markets continue to get wonky. On the flip side, QDEF will underperform in periods of rising markets. OUSA and its higher exposure to mid-caps should do much better as the company size has more growth attributes than large-caps.
Meanwhile, QUAL could be seen as the middle of the road and core option of the three ETFs, featuring a blend of defense and offense. Incidentally, most investors agree. QUAL is the largest of the three ETFS with just over $1 billion in assets.
The Bottom Line
Dividends are great when it comes to long-term total returns. But quality dividends are even better. The trio of the O’Shares FTSE US Quality Dividend ETF, FlexShares Quality Dividend Defensive ETF and iShares MSCI USA Quality Factor ETF use new smart-beta screens to craft improved portfolios and produce greater returns. Just remember that each is styled differently enough, so choosing the right one is key.
Disclosure: Author is Long QDF