Dividend growth with a quality overlay: The rationale for systemic dividend capture

• Few strategies can be as expensive as seeking dividend yield at all costs; the unintended exposures can be tantamount to a portfolio hangover.
• Integrating market factors, namely 10-year dividend growth and tail-end quality exclusions, can correct for negative fundamentals, such as low ROE and debt-financed dividends.
• Boosting benchmark yields by up to 75%, the FTSE Dividend Growth with a Quality Overlay Index family methodologically eliminates unwise exposures for a sustainable income-based portfolio.

We all enjoy the benefits of quarterly dividends—after all few commodities to life are more precious than income—but can there be too much of a good thing? The siren song of high-paying dividend companies is tantalizing, but without doing a deep fundamental dive, these businesses could be writing checks their cashflows cannot sustain. The illusion of income gives way to financial hangover.

I confess that I have personally owned strategies whose negative price return almost perfectly matched their alluring dividend yields. In essence, I paid management fees and taxes for the privilege of paying myself with my own money—this is not enjoying dividends responsibly.

A simpler, more cost-effective solution may lie in exploring dividend candidates through a factor lens. Our analysis shows that implementing a quality factor overlay has been one of the most effective means of avoiding yield traps. For example, The FTSE Dividend Growth with a Quality Overlay Index family can augment baseline equity yields on the order of 75% while eliminating companies of suspect quality. Here we explore the methodology, performance differentiation and income generation of UK and Europe ex UK variants of this unique yield strategy.

Any investment strategy involves a series of design trade-offs, and while many FTSE Russell indices utilize a factor tilt methodology, the Dividend Growth with Quality Overlay family opts for a different approach. Instead, the starting universe is modified according to a selection and elimination methodology, which makes a blunt in or out judgment on constituents as opposed to a more judicious reweighting of holdings based on factor characteristics. 

This approach commends itself when investors are willing to assume a high degree of active share and are willing to sacrifice benchmark fidelity to advance highly specific objectives, in this case dividend yield. Selection and elimination further excel when investors have an asymmetric view on factor exposure. With respect to this mandate, eliminating ultra-low-quality companies is far more critical than overweighting stocks with positive quality loads; conventional tilt-based strategies would recognize these as equal priorities.

In terms of operation, the rules on index selection fall in two buckets, those capturing yield characteristics and those reflecting quality attributes. Each March and September, basket eligibility is determined by those stocks that exhibit positive 10-year dividend growth by regression analysis, and that score at the 75th percentile for forward 12-month dividend yield. Additionally, at the industry level, companies must not rank in the bottom 10th percentile in quality z-score—here we see the factor overlay trim off tail end exposures.

Simultaneously, companies previously screened into the basket are removed if their return on equity or their 10-year dividend growth fall below zero. Forward 12-month yields beneath the 25th percentile and industry quality z-scores in the bottom 5th percentile are additional exit trigger conditions. Significantly, all of these criteria excepting the ROE and industry screens must be met for two consecutive review periods, not only to reduce turnover but to confirm the strength of signal. Collectively, these selection mechanisms condense the starting universes down to a roughly 15% residual, which is equally weighted.

Thrust into action, this twin approach of dividend growth and quality driven exclusions generates a substantial performance differential. Since December 2015, this enhanced model achieved 31.3% total return gains against conventional high dividend strategies, as represented by the FTSE UK Dividend+ Index, and the reasons for this disparity are myriad. Foremost, without implementing a quality screen, high dividend strategies will naturally gravitate to a positive value factor load, which will in turn sway active performance vis-a-vis the benchmark. Blending in quality can moderate these excesses as these two factors are not simply non-correlative, but anti-correlative. 

Second, eliminating the tail risk of low-quality companies can help avoid stocks that quote nominally high yields, but do so in consequence of a significant price drop, or the market is pricing in expected dividend cuts. In an environment of elevated and rising interest rates, companies cannot resort to the debt financing of dividends as they did for the last decade, at least not without doing so at great expense. For this reason, screening for adequate cash flow coverage and return on equity is an imperative for long-term dividend performance, as fully 71 companies in UK had a dividend yield that exceeded their ROE. Finally, the current dividend yield alone is often a poor predictor of future yields, which is why referencing historical dividend growth is a desirable complement to quality screens.

Despite what others may suggest, it is entirely possible to go out and enjoy responsible, sober dividend investing and still have a good time. Indeed, the UK and Europe ex UK Dividend Growth with Quality Overlay indexes achieved yields of 5.34% and 5.57% as of July 31, signifying 48% and 77% premiums to the yields of their respective benchmarks. Moreover, the index yields fall at the 78th and 83rd percentiles relative to companies in the starting universes for the UK and Europe ex UK. 

The disparity in yields between the two strategies reflects the diverging yield distributions in the UK and Europe ex UK equity markets—the top decile of income skews much higher in the latter than in the former. By taking a methodical approach to dividends, and the factors which undergird them for long-term investing, equity portfolios can generate meaningful income without succumbing to unsustainable yield traps.

For more on investment strategies with the FTSE Dividend Growth with Quality Index Series, contact the exchange or your broker and check out our recent joint webinar with LGIM. Please note, FTSE Russell does not distribute investment products and that these products are listed for trading on exchanges.