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How Does Your Passive Dividend Fund Avoid Risky Stocks?

Successful dividend-focused funds find harmony between risk and yield.

Actively managed equity-income funds tout their ability to put together a portfolio of stocks that offer above-market dividend yield while avoiding riskier stocks. Chasing yield can be dangerous because the highest-yielding names are more likely to have weak or deteriorating fundamentals than lower-yielding stocks, which could lead to dividend cuts. More importantly, the market identifies firms with declining fundamentals, and these stocks' prices reflect their slumping prospects ahead of them reducing or eliminating their dividend payments.

Dividend index funds use a handful of approaches to mitigate the risk of holding stocks with deteriorating fundamentals. These approaches can be roughly sorted into four categories:

1. Profitability Screens

Metrics like dividend coverage ratios, return on equity, or earnings consistency help to filter out names that may not be able to generate enough income to support their dividend payments in the future.

2. History of Dividend Payments

Dividend payment history is a backward-looking screen, but a history of consistent or growing dividend payments demonstrates a company's willingness and ability to return capital to shareholders. Long-dated screens weed out less stable companies, leaving firms with more stable fundamentals that can weather turbulent markets while consistently increasing or at least maintaining their dividend payments.

3. Stock Weighting Approach

Weighting stocks by market cap can reduce risk because larger stocks tend to be more mature and profitable than smaller stocks and because stocks with deteriorating fundamentals become a smaller part of the portfolio as their prices decline. In contrast, weighting by dividend yield tends to increase a portfolio's exposure to stocks with declining fundamentals because yields go up as prices fall.

4. Stock and Sector Caps

Funds can employ single-stock and sector caps to avoid making outsize bets. Some sectors like utilities, consumer staples, and REITs have historically paid higher dividends than " growthier " sectors like technology or consumer discretionary.

(Don't) Gotta Catch 'Em All

Passive funds primarily use the approaches from the first two categories, profitability metrics and history of dividend payments, to screen out names that may be unable to support their dividend payments in the future. More-profitable stocks are better able to support their ongoing dividend payment than less-profitable names. Although screening potential holdings based on past dividend payment or dividend growth is backward-looking, it can weed out firms that haven't been willing or able to support their dividend payments in the past.

Backward-looking screens also benefit from selection bias and favor more-stable firms that are better able to weather market turmoil and maintain their dividend payments. One drawback of a lengthy historical dividend payment screen is that it precludes some profitable firms that recently started paying dividends like Apple (AAPL, listed in the U.S.), which initiated its dividend program during the summer of 2012.

The latter two categories--weighting approach and position caps--can be thought of as approaches to reduce the impact of holding dividend-cutting funds. If a fund holds a stock with deteriorating fundamentals that cuts or decreases its dividend payments, then a market-cap-weighting approach can reduce the negative impact because the position size will decrease as its price decreases. If a fund weights its holdings by dividend yield, the fund may be upping the portfolio weighting of a name as its price decreases but its dividend yield increases. Single-stock and sector caps act as risk limits to the broader market so the fund doesn't take outsize bets that may (or may not) pay off.

When choosing among dividend funds, investors do best by keeping the following considerations in mind:

1. Does the fund target dividend growth or dividend yield?
Funds that focus on dividend growth usually hold high-quality names that tend to hold up well in down markets but may not offer the highest dividend yields. In contrast, funds that favor dividend yield are usually riskier than dividend-growth funds and land on the value side of the Morningstar Style Box.

2. How does the fund avoid buying firms that may cut their dividend payments?
Does the fund screen for profitable companies or those with long track records of paying dividends?

3. How does the fund mitigate the risk of holding stocks that cut their dividend payment?
Is the firm broadly diversified and does it weight its holdings by dividend yield?

Using these three questions as starting points and understanding the fund's investment process can help dividend investors set risk and return expectations early, which may help them better weather turbulent markets. Funds that use a handful of these risk-mitigating approaches, charge a low fee, and are broadly diversified are more likely to outperform their dividend-targeting peers on a risk-adjusted basis than those that narrowly target dividend yield.

 

About Author Adam McCullough, CFA

Adam McCullough, CFA  

Adam McCullough, CFA, is an analyst on Morningstar’s manager research team, covering passive strategies.