(PUB) Investing 2016

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Putting Dividend Funds Through Their Paces Morningstar Research | Alex Bryan

To make these distinctions clearer, we sorted each divi- dend strategy into one of three equal-sized groups along the dividend income/growth spectrum: dividend income, growth and income, and dividend growth. This score is based on the following portfolio-level metrics: • Payout ratio (forward dividend yield/earnings yield) • Dividend yield (based on expected payments over the next year) • Return on invested capital • Dividend growth of each fund during the past five years • Fund name (whether it is labeled as dividend growth) average (pre-expense) yield and payout ratio than the broad large-cap market and other two dividend groups. But their average dividend distributions slightly shrank during the trailing five years through December 2015 , which could reflect the impact of dividend cuts or a shift to lower-yielding names. Con- sistent with this slight decline, they also invested in less-profitable firms and had less exposure to stocks with Morningstar Economic Moat Ratings of wide, which signifies a durable competitive advantage. Not surprisingly, income funds tended to exhibit a more pronounced value tilt than the other two groups. There were differences in sector allocations as well. At the end of 2015 , income-oriented funds had greater exposure to the utilities, real estate, and energy sectors than growth-oriented strategies and less exposure to financial, technology, and health- care stocks. These sector tilts aren’t static. For instance, in December 2007 , income funds had greater expo- sure to financial-services stocks than dividend growth funds, but this tilt reversed after the financial crisis when many stocks in this sector cut their dividends. But the managers in each group generally fish in the same pond over time. Dividend growth funds’ average valuations and payout ratios were comparable to the corresponding figures for the broad large-cap market, and the group’s dividend yield wasn’t much higher. But this was the only group with a higher dividend growth Portfolio Comparison As expected, dividend income funds had a much higher

It isn’t hard to understand the appeal of dividend strategies. Couple historically low interest rates with increasing numbers of income-seeking retirees and it is no surprise that funds with dividend strategies have grown in popularity during the past decade. But income investors will encounter a varied landscape. At the end of January 2016 , there were 469 such U.S.-listed strategies across the open-end, closed-end, and exchange-traded fund universes, with $745 billion in assets. These funds can look and behave differently from one another depending on how they manage the trade-off between current income and future dividend growth. Dividend Growth vs. Dividend Income Firms that pay out a greater share of their earnings have less cash to reinvest in their businesses to fuel future growth. They are also more likely to cut their dividends than those with lower payout ratios because they have a smaller buffer should earnings fall. Plus, high yields can sometimes be a sign of underlying financial distress. Dividend income port- folio managers can—and often do—take steps to limit risk by applying fundamental analysis or quantitative screens to filter out high-risk names. higher payouts in the future and generally favor firms with durable competitive advantages, long divi- dend growth histories, and strong profitability. In addition, they often target firms with healthy balance sheets that suggest they are capable of boosting dividends. One trade-off is that such quality firms tend to trade at higher price multiples than stocks with higher dividend yields. That is certainly the case currently with consumer staples companies such as Coca-Cola KO and PepsiCo PEP , two popular holdings of dividend growth funds. In contrast, dividend growth managers are willing to accept lower current yields in exchange for potentially