The Dividend Awakens: A New Hope for Stable Returns in Equity Markets

Resurgence of Dividend Investing: Changing economic conditions have led to a resurgence of interest in dividend-paying stocks as investors seek ways to defend their equity portfolios amid heightened market volatility.

Growth in Dividend-Focused ETFs: Passive dividend strategies have seen significant growth, with over $300 billion in AUM in dividend-focused ETFs globally as of July 2023 (which doubled from just 3 years ago), signalling increased popularity in dividend investing.

Selecting the Dividend Index Suitable for You: Not all dividend indices are created equal, and investors must choose the one best aligned with their investment objectives. The FTSE Global Target Dividend Index Series offers an outcome driven solution that is flexible and caters to specific investor goals.

For years, growth stocks have generally dominated equity market performance, while interest in dividend-paying stocks has been lukewarm for many investors.

However, in the past couple of years, things have taken a turn. Rising inflation, higher interest rates, slowing growth and the return of market volatility have created an environment where most investors – particularly those with long investment horizons and relatively low risk appetites have needed to search for ways to defend their equity portfolios while seeking pockets of upside. As a result, dividend-paying stocks, the instruments that typically offer downside protection to an equity investor by boosting return and dampening volatility, have started to take on greater prominence.

As of 31 July 2023, passive implementation of dividend strategies has measured over US$300 billion, based on the total assets under management (AUM) of dividend-focused ETFs globally, according to Lipper data. This is an incredible rise considering that the AUM has effectively doubled in just over 3 years (combined AUM from the same pool of ETFs amounted to just over US$150 billion as of 31 July 2000). This rapid growth in assets is a testament to the gain in the popularity of dividend investing in recent years.

One way for investors to access dividend stocks is via passive investment that is benchmarked to a dividend index.

However, not all dividend indices are created equally. For example, some indices target a high dividend yield by utilizing yield ranking, while some focus on the consistent growth of dividend payments. As a result, these types of dividend indices are likely to skew towards industries that typically pay higher dividends, such as energy and financials.

The approach of the FTSE Global Target Dividend Index Series stands out as something fresh and innovative. The series employs an outcome-driven, flexible framework methodology. It utilizes FTSE Russell’s Target Exposure methodology to derive its index composition given a set of model parameters and active factor exposures.

The merits of the FTSE Global Target Dividend Index Series design include the flexibility to set a primary goal of reaching a dividend yield uplift vs. the base universe, together with the ability to incorporate various controls (such as turnover limit) and desired active factor exposures (such as quality factor uplift) to suit investors’ objectives.

For example, investors may wish to place a heavier focus on the quality of dividends particularly during periods of market turbulence – this means paying attention to certain metrics of dividend payers, such as free cash flow and interest costs. The FTSE Target Dividend index can cater to this requirement by setting a higher active quality factor exposure – a factor that takes into account a company’s profitability (as measured by return on assets, changes in asset turnover, and accruals) and leverage (as measured by operating cash flow to total debt ratio). This framework helps to select companies that are capable of maintaining a relatively more stable dividend yield, even during times of market stress, as well as potentially delivering outperformance over a long-term investment horizon.

The differences in dividend index designs will exert various degrees of impact on index performance. It is therefore critical that investors understand the methodology of the underlying benchmarks they use for their passive dividend exposure.

Despite this approach, unexpected dividend cuts and even the elimination of dividend payments, remain common challenges to income seekers. Additionally, indices that are designed to simply reach for the highest-yielding dividend stocks, often carry a greater risk of having high-yielding constituent companies that are caught in a “dividend yield trap”.

The trap refers to a situation where a company’s high dividend yield is caused by decreasing stock prices rather than increasing dividend payments. This is more commonly observed during turbulent markets where stock prices swing wildly. If a stock price falls sharply, its dividend yield will skyrocket. While this may look like the company is offering a fantastic dividend yield, in reality, it can be an indicator that the company is seeing deteriorating financial health.

To mitigate this risk, the FTSE Global Target Dividend Index Series incorporates mechanisms to tackle extreme yielding stocks among dividend-paying companies. A statistical measure called the “Robust Z-score”, together with another measure on “momentum percentile”, enable the index series to detect and exclude stocks with extreme dividend yields that experience extreme negative returns.

As market volatility continues, dividends have become a more significant and stable contributor to total returns. Investors who are less eager to go all-in on high-multiple growth stocks against the current market backdrop are paying more attention to dividend investing. This renewed appreciation of dividend stocks can potentially play a bigger role in investors’ portfolios.

It is important to remember that not all dividend-paying companies represent a great investment. Being selective and understanding which benchmark approach works best for your investment objectives will go a long way in helping you strive for outperformance in your equity portfolio.