IQ INSIGHTS. Are All Dividend Equity Strategies Created Equal?

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1 IQ INSIGHTS Are All Dividend Equity Strategies Created Equal? by Matthew J. Arnold, CFA, Senior ETF Strategist SPDR ETFs Dividend equity investing has experienced something of a renaissance in recent years, as investors have sought alternatives to low-yielding core fixed income assets. In addition to compensating for the low levels of income generated by traditional sources, investors have been attracted by the defensive qualities of some dividend-based strategies. Burnt by two severe bear markets since 2000, investors on both sides of the Atlantic have found comfort in dividend and low volatility equity strategies, believing each offers a means of participating in the equity market while reducing volatility and potential drawdowns. But are all dividend strategies created equal? And what should investors think about when implementing a dividend-based approach to equity investing? Here, we examine the results of several index-based high dividend equity strategies and make several suggestions for investors evaluating their dividend equity options in the current environment. We show that index strategies incorporating some element of dividend sustainability, such as a requirement for constituents to exhibit a consistent record of growing dividends, have performed better than naïve indexing approaches, where constituents are selected on trailing yield alone. We also show that dividend growth strategies have delivered in terms of lowering volatility and reducing average drawdowns over time. In short, we contend that not all dividend approaches are created equal and that as with most investment strategies, the devil is often in the detail. A Brief Recap The Income Challenge The low interest rate environment of the last several years has fundamentally changed the landscape for income-oriented investors. Bank deposits pay near-zero interest rates, yields on many stable net asset value cash funds barely cover expenses and core fixed income assets currently generate meagre levels of income. Partly as a function of the interest rate environment, but also likely a reaction to the two brutal bear markets experienced since 2000, dividend-based equity strategies have recently been exceptionally popular with investors the world over. But as with most investment approaches there are numerous ways to gain exposure to the high dividend equity beta. What an investor wants to get out of their dividend-based strategy is also a consideration. Are they looking to outperform the cap-weighted market, be that over the short or long term? Or are they looking to generate a little income and perhaps invest in the equity market in a slightly more defensive manner? Certainly, if the goal is to outperform the broad market, results are likely be time dependent. Dividends being a traditional value factor will likely perform well during periods when stocks with value characteristics do well. On the flipside, they will likely struggle where growth-oriented characteristics are more highly valued by the market. In any case, there are many things to think about when adopting a dividend-oriented investment strategy.

2 The S&P 500 Dividend Aristocrats Index is designed to measure the performance of large cap companies within the S&P 500 index which have followed a manageddividends policy of increasing their dividends every year for the last 25 years, subject to various market capitalisation and liquidity requirements. The constituents are equally weighted and the index is rebalanced quarterly. The index is reconstituted annually in January. S&P has also created Dividend Aristocrats indices covering other markets. The markets and a brief description of the methodologies are detailed below: S&P High Yield Dividend Aristocrats index tracks S&P 1500 companies that have grown dividends for 20 years, subject to various market capitalisation and liquidity constraints. The index is dividend-weighted, with all qualifying companies added to the index. This index is the benchmark for two SPDR ETFs, one domiciled in the US, one domiciled in Europe. S&P UK High Yield Dividend Aristocrats index tracks UK companies within the S&P Europe BMI index that have grown or maintained stable dividends for at least 10 years. It is dividend-weighted, with only the top 30 (by dividend yield) companies included in the index. In addition to liquidity and market capitalisation constraints, sector weights are capped at 30. This index is the benchmark for a European-domiciled SPDR ETF. S&P Euro High Yield Dividend Aristocrats index tracks eurozone companies within the S&P Europe BMI index that have grown or maintained stable dividends for at least 10 years. It is dividend-weighted, with only the top 40 (by dividend yield) companies included in the index. In addition to liquidity and market capitalisation constraints, both sector and country weights are capped at 30. This index is the benchmark for a Europeandomiciled SPDR ETF. S&P Global Dividend Aristocrats index tracks companies within the S&P Global BMI index that have grown or maintained stable dividends for at least 10 years. It is dividend-weighted, with only the top 100 (by dividend yield) companies included in the index. In addition to liquidity and market capitalisation constraints, both sector and country weights are capped at 25. This index is the benchmark for two SPDR ETFs, one domiciled in the US, one domiciled in Europe. S&P Pan Asia Dividend Aristocrats index tracks companies within the S&P Pan Asia BMI index that have grown their dividends for at least 7 years. It is dividend-weighted, with a maximum of 100 constituents included in the index. The minimum number of constituents is 40. In addition to liquidity and market capitalisation constraints, both sector and country weights are capped at 30. This index is the benchmark for a European-domiciled SPDR ETF. Source: S&P Dividend Aristocrats index methodology papers. For more information including full criteria and exceptions to the above, please consult spdji.com. For information on the corresponding SPDR ETFs, please consult spdrs.com or spdrseurope.com Dividend Growth versus Dividend Yield What Performs Best? What makes a successful dividend equity strategy? And how can investors go about implementing a dividend-based strategy efficiently? From simply screening a universe of stocks by trailing dividend yield to buying a basket of stocks from a traditional high yielding sector such as utilities, there are many means of gaining exposure to the dividend theme. Many investors simply hire an active fund manager, leaving them to build a portfolio of stocks that delivers a relatively high level of current income. The Equity Income category, one of the largest fund categories in Europe, has long been the domain of the active manager, with passive options few and far between until a few years ago. Their approaches vary significantly: some managers emphasise yield alone, while others favour companies that have shown an ability to grow their dividends over time. There are a range of index fund and ETFs available too, from sector funds through to funds that track customised high dividend equity indices. Broadly speaking the various implementation options can be divided into those that focus on dividend growth and those that focus on dividend yield. We examine the merits of each approach below. According to Ned Davis Research, the sell-side research house, US companies that have grown their dividends or initiated a dividend payment have outperformed companies employing alternative dividend strategies over the long term. Their analysis compared the performance of stocks in the S&P 500 based on the company s dividend policy. They constructed equal-weighted portfolios of stocks that fell into the following categories: 1. Dividend Growers and Initiators 2. All Dividend-Paying Stocks 3. Dividend Payers with no Change in Dividends 4. Non-Dividend-Paying Stocks State Street Global Advisors 2

3 Figure 1: Performance Since 1990 Dividend Aristocrats versus Naïve Sector Strategies Dividend Aristocrats S&P 500 Equal Weighted Financials Utilities Telecoms S&P 500 Source: Morningstar Direct, S&P Dow Jones Indices. Dec 1989 Jun Equal weighted S&P 500 Dividend Aristocrats, Financials, Telecoms, S&P 500 and Utilities indices and the S&P 500 index. Total cumulative return in USD. Past performance is no guarantee of future results. Figure 2: Average Rolling Returns Dividend Aristocrats versus Naïve Sector Strategies Dividend Aristocrats Average 3 Year Rolling Return Financials Telecoms Utilities S&P 500 Equal Weighted Average 5 Year Rolling Return S&P 500 Source: Morningstar Direct, S&P Dow Jones Indices Dec 1989 Jun Equal weighted S&P 500 Dividend Aristocrats, Financials, Telecoms, S&P 500 and Utilities indices and the S&P 500 index. Average 3 and 5 year rolling total returns (annualised) in USD. Past performance is no guarantee of future results. The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income Since 1972, the Dividend Growers and Initiators averaged total annualised returns of 9.9, outperforming stocks in the other three categories. Dividend Payers with No Change in Dividends returned 7.5 annually, while Non-Dividend- Paying stocks delivered only 2.2 annually. This compared to the 7.4 annual gain for the equal-weighted S&P 500 Index. 1 They expanded their research to look at stocks in Europe, and while the history is shorter (data here goes back to 1987), results were similar with Dividend Growers outperforming other categories. 2 Analysis of the S&P 500 Dividend Aristocrats Index provides further evidence of strong performance from companies that have shown the ability to grow their dividends over time. The S&P 500 Dividend Aristocrats is an equal-weighted index consisting of S&P 500 constituents that have grown their dividends for at least the last 25 years. The index has history back to We compared the performance of that index to the equal-weighted S&P 500 index, and two high yield sectors, Telecoms and Utilities. Simply buying either or both sectors for yield alone is perhaps an example of a naïve investment strategy one that exposes investors to risks above and beyond the exposure to the high dividend equity factor. Telecoms for instance experienced a significant boom and bust during the late 1990s and early 2000s, their performance the result of sector-specific issues far more than them being historically high dividend payers. Likewise, Utilities stocks have been bid up over the last several years but suffered something of a setback in May 2013 when US Fed Chairman, Ben Bernanke, announced the possibility that bond purchases would be tapered. Since one of the attractive elements of a well-executed dividend strategy is reduced volatility and increased downside protection, these naïve approaches thus fall short in some regards. As illustrated in Figure 1, our own research appears to confirm the results of the Ned Davis study. The broad-based S&P 500 Dividend Aristocrats Index has outperformed the sector indices as well as the S&P 500 equal- and capitalisation-weighted indices. A word of warning, however: the strong long-term results of the dividend growth strategy, as represented by the S&P 500 Dividend Aristocrats index, should not hide the fact that results are very much time-dependent. If one evaluated the strategy towards the end of the 1990s for example, both naïve sector-based approaches would have outperformed the Dividend Aristocrats approach. And if we evaluate the strategies based on the average rolling 3-year returns (see Figure 2), the Financials sector strategy actually generated a higher average 3-year annualised return. Nonetheless, at almost a quarter of a century, the cumulative results are indeed quite robust, incorporating the tech and telecom boom and bust, the credit bubble and the global financial crisis that followed. Are Dividend Equity Strategies Less Volatile than the Market? We hear from investors that one of the main attractions of adopting a high dividend-based equity strategy is the prospect of reducing overall portfolio volatility. But have high dividend stocks really delivered on that front? State Street Global Advisors 3

4 Figure 3: Price Volatility Dividend Aristocrats versus Naïve Sector Strategies 3 Years () 5 Years () 10 Years () 15 Years () 20 Years Since Dec 1989 () Dividend Aristocrats Financials Telecoms Utilities S&P 500 Equal Weighted S&P Source: Morningstar Direct. Dec 1989 June Equal weighted S&P 500 Dividend Aristocrats, Financials, Telecoms, S&P 500 and Utilities indices and the S&P 500 index. Standard deviations based on total return indices using monthly data in USD. Past performance is no guarantee of future results. Analysing the long-term results it is clear that the Dividend Aristocrats have been less volatile than the broad market and have also offered some downside protection. From December 1989 through to December 2013, the annualised standard deviation was 13.77, less than both the equal-weighted and cap-weighted S&P 500 indices, while the average drawdown over that period was -8.57, also less than the broad market indices. Clearly, in times of market stress, Steady Eddies companies that have been able to grow dividends through good times and bad times generally hold up much better than the more cyclical companies whose businesses experience ebb and flow in line with the broader economic conditions. This lower volatility combined with a strong record of returns, contributed to the index having a higher Sharpe ratio over all time periods than all of the alternative strategies below. The risk of single sector strategies is clear, with financials and telecoms indices having maximum declines of close to 80 certainly not what is sought by the typical dividend equity investor. When Do Dividend Aristocrats Outperform? Earlier, we highlighted the strong results of the Dividend Aristocrats approach when viewed on an average rolling 3- and 5-year basis. On a calendar year basis, the evidence is just as compelling. The S&P 500 Dividend Aristocrats index has declined in just four out of 24 calendar years 1999, 2002, 2007 and was the tail end of the technology and telecom boom while 2007 marked the beginning of the global financial crisis and 2008 were bear markets, with the equal-weighted index declining and 39.72, respectively. In these years, the Dividend Aristocrats index declined 9.87 and 21.88, significantly less than the broader market. Despite the strong long-term results, the Dividend Aristocrats index only outperformed the equal-weighted index half the time, generally underperforming in years when the more cyclical stocks have been favoured by the market. These results highlight again that while companies that have shown an ability to grow their dividends have performed well over the long term, there have been periods where this characteristic has not been rewarded by the market. This has implications for investors, particularly those with a relative return orientation. Figure 4: Performance Since 2000 Dividend Aristocrats versus Dogs of the Dow Dividend Aristocrats S&P 500 Dow Jones Industrial Average S&P 500 Equal Weighted Dogs of the Dow Source: Morningstar Direct, S&P Dow Jones Indices. Dec 2000 Jun Equal weighted S&P 500 Dividend Aristocrats and S&P 500 indices, Dow Jones Industrial Average, Dow Jones High Yield Select 10 index and S&P 500 index. Total cumulative return in USD. Past performance is no guarantee of future results. The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. Sector Weights are as of the date indicated, are subject to change, and should not be relied upon as current thereafter. Dividend Aristocrats versus Dogs of the Dow Much space in investment publications has been given to the Dogs and the Dow theory. In essence the strategy involves blindly investing in the highest yielders in the Dow Jones Industrial Average at the beginning of the year, at an equal weight, and holding them until the end of the year. You might say this is the ultimate naïve investment strategy investing in stocks solely based on historic dividend yield, with no regard to sustainability or diversification and is similar to methodologies employed by some of the more basic dividend equity indices currently available in the market. While it may have beaten the Dow Jones Industrial Average itself an anarchic price weighted index how has this strategy done relative to the S&P 500 Dividend Aristocrats index? Unfortunately, we do not have a track record going back to 1989 State Street Global Advisors 4

5 Figure 5: Price Volatility Dividend Aristocrats versus Dogs of the Dow Inception Date Std Dev 3 Yr (Qtr-End) USD Std Dev 5 Yr (Qtr-End) USD Std Dev 10 Yr (Qtr-End) USD Std Dev to USD Dividend Aristocrats 12/29/ 'Dogs of the Dow' 12/29/ S&P 500 Equal Weighted 12/29/ S&P 500 TR USD 1/30/ DJ Industrial Average TR USD 9/30/ Source: Morningstar Direct, S&P Dow Jones Indices. Dec 2000 June Equal weighted S&P 500 Dividend Aristocrats and S&P 500 indices, Dow Jones Industrial Average, Dow Jones High Yield Select 10 index and S&P 500 index. Standard deviation based on monthly total returns in USD. Past performance is no guarantee of future results. for the Dogs of the Dow strategy, but with a history which goes back to 2000 we have a reasonable length of time to judge its success. It has indeed outperformed the Dow Jones Industrial Average, but it has significantly underperformed the S&P 500 Dividend Aristocrats index. As one might expect, the Dividend Aristocrats index has proved to be considerably less volatile than the Dogs of the Dow since the inception of the official index (Dow Jones High Yield Select 10) in Over this time period at least, the high quality dividend growth approach has clearly outperformed the naïve approach, both in terms of superior performance and more favourable risk characteristics. This work seems to suggest that dividend growth, rather than dividend yield, is the factor that investors should evaluate when building a dividendbased equity portfolio. Implementing a High Dividend Equity Strategy While the current low rate environment has contributed to the popularity of dividend-based equity strategies, we believe they represent a time-tested means of investing in the equity market. We think investors considering a high dividend equity approach should ask themselves the following questions: 1. What are we trying to achieve with our dividend equity program? Are we solely looking to increased levels of current income or are we also attempting to lower the volatility of our equity portfolio and/or increase the quality characteristics? 2. Are we attempting to outperform the broad market indices over time and/or are we looking to capitalise on current valuation opportunities? 3. Are we comfortable accepting the style bias present in most high dividend strategies or will we require offsetting investments? 4. Do we believe in active management of dividend equity strategies or do we prefer to gain exposure to the high dividend equity beta passively through index funds and/ or ETFs? Figure 6: Sector Weighting Over Time S&P High Yield Dividend Aristocrats Index Consumer Discretionary Health Care Materials Consumer Staples Industrials Telecommunication Services Energy Information Technology Source: FactSet, S&P Dow Jones Indices. Quarter-end sector weights. Financials Utilities Thoroughly considering the questions above should help investors as they evaluate the various implementation options. We find that the active versus passive question is often not a case of either/or. Many investors choose to gain exposure to asset class segments through both active and passive strategies. Other Considerations The Changing Shape of Dividend Aristocrats While the universe of US companies which have grown their dividends each and every year for 25 years is relatively constant, there are changes over time as companies merge and markets evolve. This may present challenges for investors attempting to make broad valuation calls based on what an index traded at historically versus its current levels. If we look at the S&P High Yield Dividend Aristocrats index for example, the benchmark for two of our most popular SPDR ETFs (one domiciled in the US, one domiciled in Europe) we can see that the sector weights of that index have changed since its inception in State Street Global Advisors 5

6 Figure 7: Historic Dividend Yield S&P High Yield Dividend Aristocrats Index Versus S&P S&P High Yield Dividend Aristocrats S&P 500 Source: FactSet, S&P Dow Jones Indices. Quarter-end trailing dividend yield (gross). Past performance is not a guarantee of future results. Figure 8: Historic Price-to-Book Ratios S&P High Yield Dividend Aristocrats Index versus S&P S&P High Yield Dividend Aristocrats S&P 500 Source: FactSet, S&P Dow Jones Indices. Quarter-end trailing dividend yield (gross). Past performance is not a guarantee of future results. Further complicating the issue is the fact that S&P Dow Jones Indices have evolved their index methodology over time, both in terms of number of constituents from 50 companies at inception, to all qualifying today and years of dividend growth required from 25 years at index inception to 20 years today. As the chart above illustrates, the sector weights of this index have changed over time, with less weight in financials and more weight in consumer staples in recent times. Relative valuation characteristics have also changed over time, and while some of the increase in valuation of the S&P High Yield Dividend Aristocrats index may be a function of investor demand for high quality dividend paying companies it is also reflects the different make-up of the index. The exhibits below also raise an interesting question that we will examine in a later paper. Has the strong performance of S&P s Dividend Aristocrats indices been purely a function of investors rewarding companies that have shown the ability to grow their dividends over time, or have they actually been paying for exposure to the quality factor, typically measured by earnings variability, debt to equity ratios and return on equity? Conclusion High quality dividend investing has stood the test of time. While Steady Eddies like S&P s Dividend Aristocrats are unlikely to capture the imagination in the way that a Twitter or a Facebook might, they have an enviable record of long-term wealth generation and have delivered through the full range of market cycles. They may offer slightly lower levels of current income, but we believe diversified strategies incorporating some element of dividend growth are superior to single sector and pure yield-based approaches, offering both strong return and risk reduction potential. And, as we ve shown, not all dividend strategies are equal judicious choice of an index that that targets consistency in dividend growth can offer very real benefits to investors in terms of performance. Notes: The author would like to thank Ned Davis Research. 1 Returns of S&P 500 Stocks by Dividend Policy. 31 January 1972 to 30 September Ned David Research. Past performance is no guarantee of future results. 2 Returns of MSCI UK and MSCI Europe ex-uk Stocks by Dividend Policy. 31 December 1987 to 30 September Ned Davis Research. Past performance is no guarantee of future results. State Street Global Advisors 6

7 Appendix Appendix Figure 1: Calendar Year Returns Dividend Aristocrats versus Naïve Sector Strategies Dividend Aristocrats Financials Telecoms Utilities S&P 500 Equal Weighted S&P 500 Dogs of the Dow Dividend Aristocrats Outperforms* Yes Yes No No No Yes Yes Yes Yes No Yes Yes Yes No No No Yes No Yes No No Yes No No Yes 2015 YTD No Source: Morningstar Direct, S&P Dow Jones Indices. Equal weighted S&P 500 Dividend Aristocrats, Financials, Telecoms, S&P 500 and Utilities indices and the S&P 500 index. Calendar year total returns in USD. Dogs of the Dow represents Dow Jones High Yield Select 10 index. Dividend Aristocrats outperforms is yes in years when the S&P 500 Dividend Aristocrats Index outperforms the S&P 500 Equal Weighted Index. Past performance is no guarantee of future results. The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. Appendix Figure 2: Drawdown and Risk-Adjusted Returns Dividend Aristocrats Versus Naïve Sector Strategies Max Drawdown () Average Drawdown () Sharpe Ratio 10 years Sharpe Ratio 15 Years Sharpe Ratio 20 Years Sharpe Ratio since Dec 1989 Dividend Aristocrats Financials Telecoms Utilities S&P 500 Equal Weighted S&P Source: Morningstar Direct, S&P Dow Jones Indices. Dec 1989 June Equal weighted S&P 500 Dividend Aristocrats, Financials, Telecoms, S&P 500 and Utilities indices and the S&P 500 index. Past performance is no guarantee of future results. Sharpe ratio is arithmetic calculation based on monthly returns. Risk free rate is US Treasury T-Bill Auction Average 3 mth rate. Past performance is no guarantee of future results. The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. State Street Global Advisors 7

8 Appendix Figure 3: Drawdown and Risk-Adjusted Returns Dividend Aristocrats Versus Dogs of the Dow Max Drawdown () Average Drawdown () Sharpe Ratio 10 Years Sharpe Ratio Since Dec 2000 Dividend Aristocrats 'Dogs of the Dow' S&P 500 Equal Weighted S&P DJ Industrial Average Source: Morningstar Direct, S&P Dow Jones Indices. Dec 2000 Jun Equal weighted S&P 500 Dividend Aristocrats and S&P 500 indices, Dow Jones Industrial Average, Dow Jones High Yield Select 10 index and S&P 500 index. Sharpe ratio is arithmetic calculation based on monthly returns. Risk free rate is US Treasury T-Bill Auction Average 3 mth rate. Past performance is no guarantee of future results. The index returns are unmanaged and do not reflect the deduction of any fees or expenses. The index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. ssga.com For institutional use only. Not for use with the public. 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T: F: United States: State Street Global Advisors, One Lincoln Street, Boston, MA T: The views expressed in this material are the views of the Matthew J. Arnold, through the period ended August 31, 2015 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Investing involves risk including the risk of loss of principal. Risk associated with equity investing include stock values which may fluctuate in response to the activities of individual companies and general market and economic conditions. The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. 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