Those yields, however, come with a cost. Investing 101 teaches us that higher return potential often comes with higher risk. In the equity markets, this is especially true. Traditionally conservative sectors such as utilities and consumer goods are sporting valuations far above historical norms as investors continue to pile into these traditionally higher yielding areas. Opportunities still exist for yield seekers but these individuals need to be very diligent in choosing the right stocks.
Smart beta strategies that focus on high quality dividends as opposed to just high dividends are becoming increasingly attractive options. One of my favorites is the FlexShares Quality Dividend Index Fund ETF (NYSE:QDF). This is an ETF that not only manages a yield roughly 30% higher than the S&P 500, but also manages to strip out a significant chunk of dividend risk in the process.
The key is in the ETF’s focus on a company’s overall financial health as opposed to just strictly fundamental metrics like the payout ratio. The FlexShares approach looks at management efficiency, profitability and cash flow in order to create a proprietary dividend quality score. Non-dividend payers and companies in the lowest quintile get rejected immediately. The fund focuses on stocks in the highest quintiles while balancing dividend yields and putting diversification controls in place to fill out the portfolio.
The result is a portfolio that at a high level doesn’t look all that dissimilar to the S&P 500 but is much cleaner on the inside. The Quality Dividend ETF is currently overweight financials, which could benefit from an impending Fed rate hike, and utilities, an area of the market traditionally more conservative while delivering above average yields. It’s underweight primarily in the healthcare and technology sectors.
Clean, quality dividends are more important today than maybe any time since the financial crisis. Earlier this year, Fitch raised its 2016 forecast on high yield debt defaults up to 6% overall, while saying that defaults in the troubled energy sector could surpass 20%. While dividend payments on equities and principal repayments on debt aren’t the same thing, it does suggest that the overall economic environment is making payments to shareholders a little less certain.
The fund is a nice option for investors looking for a core dividend holding for their portfolios. Its 2.7% yield significantly beats the S&P 500 yield while providing greater dividend stability and comparable risk. The fund’s 0.37% expense ratio is a tad on the high side but it still manages to earn Morningstar’s highest five-star rating.
Not all dividends are created equal. In today’s market, seeking out strong dividends instead of high dividend yields may be the best course of action.
David Dierking is a freelance writer focusing primarily on ETFs, mutual funds, dividend income strategies and retirement planning. He has spent more than 20 years in the financial services industry and his background includes experience in investment management, portfolio analytics and asset/liability management at both BMO Financial Group and Strong Capital Management.
He has written for Seeking Alpha, Motley Fool, ETF Trends and Investopedia and was also included in the panel for ETFReference.com’s “101 ETF Investing Tips from the Experts”. He has a B.A. in Finance from Michigan State University and lives in Wisconsin with his wife and two daughters.