Thanksgiving isn’t just a time for giving thanks, for some investment professionals, it’s an occasion for market research. Between squabbling cousins and the Lion’s annual shellacking, an attentive listener can tell how far the incipient correction has run just by the questions asked around the dinner table. Is your grandmother asking about CD rates, while your crazy uncle talks non-stop about gold as a store of value? If so, then the correction might have a lot more room to run as your relatives “de-FAANG” their portfolios to make room for “safe” investments.
Fortunately for the markets, not every investor is rushing to de-risk their portfolio by turning back to cash. Instead, some turn to dividend funds for their combination of lower volatility and income potential, with many of the products from the largest sponsors like Vanguard and State Street seeing substantial inflows. However, a frequent topic we discuss is that not all dividend funds are created equal, something now more important than ever thanks to the latest correction.
Dividend income funds typically fall into one of two categories: Some funds simply pick the highest dividend payers from a limited universe, like the S&P 500, which typically leaves you with a lot of utility and consumer staples exposure and not much else. The other category is made up of funds that apply highly complicated formulas dependent on long-term accounting data to determine whether a dividend is sustainable. This approach winds up with a much smaller, more highly concentrated fund built using outdated information. We went looking for funds that could bridge the gap between those two approaches and found a new fund sponsor with a series of products that could offer the best of both worlds.
Advisors Asset Management, founded in 1976, isn’t new to the world of investment solutions, although their first forays into the world of Exchange-Traded Funds only date back to November 2017. Their fund lineup is devoted to the dividend or equity income space with the AAM S&P 500 High Dividend Value ETF (SPDV) and the AAM S&P Emerging Markets High Dividend Value ETF (EEMD). SPDV and EEMD now have one-year track records and will soon be joined by the AAM S&P Developed Ex.-U.S. Dividend Fund (DMDV), which is launching at the end of November. At first glance, their two current products would seem to fit the mold of another series of generic dividend funds, especially if ETF names are any judge of the actual strategies, but don’t be so quick to judge these books by their cover.
Their names are accurate in defining their respective geographic focuses and, as most obvious in the case of SPDV, all three rely on indices provided by S&P Dow Jones where having a high dividend is just one of the attributes for which they screen. In fact, their funds have abbreviated names that cut off the reality that their respective benchmarks are built not just on dividend yields, but free cash flow (FCF) yield as well. As we’ve pointed out, looking at just high dividend yields is a sure-fire way to wind up with a stealth utilities fund, but that’s only one potential danger. A much bigger one is when a company’s share price has been beaten down, resulting in a high dividend yield, but which may prove to be an accounting illusion. Just ask investors in General Electric (GE).
Instead, all three AAM products rely also on free cash flow (FCF) yield to help determine dividend sustainability in building out their portfolio’s. Why use FCF to judge sustainability? There’s a wealth of information available from S&P Dow Jones on the past returns for high dividend payers with strong free cash flow, but a simpler answer is found in basic corporate finance. Dividends do have to be “paid” for, as earnings that could go towards acquisitions or capital expenditures are returned to shareholders instead, making FCF the most direct way to measure the ability of an enterprise to sustain itself. But another, and perhaps more visceral, answer is that FCF is often free of the accounting distortions present in most quarterly and annual reports using GAAP.
All three funds rely on the same process for building out their portfolios, although they have vastly different selection universes. SPDV obviously begins with the S&P 500, while EEMD utilizes the S&P Emerging Plus LargeMidCap Index with distinct liquidity constraints that keeps the equally-weighted allocation from having a small-cap feel. Twice a year the index provider will rank every constituent in the respective universes by dividend and free cash flow yield over the trailing 12 months with the components whose yields are in the bottom and top 2.5% percentiles will have their yields adjusted to match those on the threshold. That relatively minor modification helps keep both portfolios from being overly impacted by those outliers we already mentioned whose yields might look distorted thanks to a major price hit. A good example would be S&P component L Brands (LB), currently sporting a dividend yield north of 8%, following a more than 50% drop YTD.
But those ranks are only part of the process; both the dividend and FCF scores are normalized and then combined to arrive at a final score which determines the actual allocations. In practice, this means a stock needs to have both an attractive FCF and dividend yield within their sector to make the cut into the portfolio. The timing of their last reallocation in July, near the peak of the market, meant that SPDV and EEMD have very distinct value orientations, along with smaller average overall market caps than the average large value or emerging market equity funds.
AAM’s process might seem straight forward, but not so much so that you create a portfolio of just utilities and consumer staples stocks. In fact, their funds are designed to keep just that from happening thanks to a weighting system that puts the top five highest scoring stocks in each GICS sector into each fund rather than just packing the funds with the top highest scorers overall. Next, the individual components are equally weighted, which gives the fund higher exposure to traditional defensive sectors like utilities and consumer staples than you would find in the S&P 500. Additionally, this process still enables exposure to more core or growth sectors like technology, while avoiding going all-in on late-cycle value traps, like bank stocks.
Now throw the shortly-to-be-launched DMDV that will fill the gap in the AAM line-up. As the name implies, the fund relies on the S&P Developed Ex-U.S. Dividend and Free Cash Flow Yield Index to offer exposure to select dividend paying stocks in developed markets, while excluding not just the United States but South Korean stocks from its portfolio as well. DMDV will follow the same index rules that govern its two existing products, making it easy for current investors to understand, but a challenge for investors used to simpler funds. Unfortunately, investors that haven’t found the AAM series yet could find themselves missing out on a significant new trend in dividend income funds.
The net result of AAM’s portfolio construction strategies and, why we’re so interested in the AAM series of funds, is that they tend to have a higher correlation to the broader equity markets than most dividend funds while retaining most of the advantages of their competitors. While a one-year track record isn’t the most exhaustive we could hope for, a factsheet provided by AAM points out that their largest fund, SPDV, had outperformed a host of other funds tied to the S&P 500 in 2018 through the end of September. This outperforming occurred while delivering a comparable dividend yield and slightly lower volatility and downside capture than other funds in the space. How they did that was by having a slightly higher correlation to the S&P 500, which allowed it to pick up a significant chunk of the market’s gains in the first half of the year while not taking in all the losses on the back end.
How does that translate into actual performance during a period of higher volatility? Both SPDV and EEMD have outperformed their broader categories over the past month (through 11/27), as tech and energy names have sold off, while even interest rate sensitive utilities haven’t been spared the rod. That’s helped SPDV’s more balanced approach find some favor, a major challenge at this point considering its current allocation dates to last July. However, the fund will undergo a reconstitution again in January and the need to have representation to every GICS sector will ensure a more diversified portfolio no matter what.
A good way to understand their strategy is to study the biggest winner in SPDV’s portfolio over the last three months, consumer staples favorite Walgreens Boots Alliance Inc (WBA), up over 18.5%. SPDV’s 2.4% allocation is hardly the largest out there, we show 17 other ETF’s with larger positions but those are almost entirely by pure consumer staples funds, typically not a big “must have” for individual investors. Only the titanic Vanguard Dividend Appreciation Fund (VIG) has a position even close to 2% with most funds having positions of 1% thanks to a broader portfolio with hundreds of positions. SPDV’s focus on only the top five in each sector means a much more concentrated portfolio of “best names” rather than an “anyone-can-come” solution.
That sector rotation has hurt some larger dividend funds but that’s only part of the story. A clear rotation out of technology stocks isn’t the only noticeable trend of the past few weeks, developed market stocks have begun to outperform their U.S. peers. Answering why that is could make even the most easygoing economist froth at the mouth. Disparate central bank policies and a worsening of the U.S. economic outlook are the most commonly cited reasons for this, although that “why” isn’t all that important. That investors are looking for more diversified sources of income is what counts, making the launch of DMDV all the timelier.
So, while the AAM series of dividend funds might be new, they have already begun to demonstrate their value to investors looking for a more balanced approach to equity income.
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