Investors traditionally have looked to dividend paying stocks for the opportunity to enhance a portfolio’s risk-adjusted returns and provide a source of income. Without careful construction, however, high-dividend portfolios may expose investors to both unintended and uncompensated risks that potentially impair the investor’s objective to produce consistent income and enhance returns—while also failing to meet sustainable investing objectives.
When investing in any strategy, we feel it is essential to focus on areas where investors are getting paid to take risks, and to avoid taking risks where investors are not getting paid. We believe that incorporating the return-enhancing potential of factor investing alongside the risk-mitigation characteristics of sustainability can potentially strengthen a dividend investing strategy.
In this paper, we offer a closer look at some of the risks of dividend investing strategies in the context of a changing economy. We then explain the proprietary methodology that Northern Trust Global Investments Limited used to assemble an index of high-quality dividend paying companies that also have favorable sustainability profiles and are managing well the risks and opportunities arising from the transition to a low-carbon economy.
For decades, investors have looked to stock dividends to provide income in their equity portfolios. The recent trend of persistently low interest rates has made dividend paying stocks even more valuable as a diversifier to traditional fixed-income investments.
Successful dividend investing requires identifying companies that can consistently pay and grow dividends over the long term. However, many funds that track traditional dividend-focused indexes expose investors to unintended risks that may threaten the sustainability of those dividend payments and impair risk-adjusted returns. These funds also may not meet investors’ sustainability goals.
In order to achieve income objectives, dividend strategies have often focused on companies that traditionally are considered high-dividend payers. High-dividend payers tend to be concentrated in mature industries, so certain sectors and regions tend to have higher payouts than others. This results in a significant concentration of sector and regional allocations that may add to a portfolio’s risks, but not necessarily to its returns.
These allocations may also result in a portfolio that holds companies that are poorly managing their ESG risks and opportunities, or that demonstrate a higher carbon footprint such as found in mature industries like energy and utilities. The companies in these sectors tend to have a higher carbon footprint relative to other parts of the economy—thereby exacerbating the potential impact of climate risk.
Many times, a higher dividend yield also is the result of a price decline—what are often referred to as “dividend traps.” Seemingly cheap high-dividend stocks may be traps, as their attractive dividend yield may be the result of markets pricing in their impaired fundamentals. Our research suggests that such price declines generally precede dividend cuts.
In our view, a dividend investing strategy must take a holistic view to help assess the potential sustainability of dividend payments and avoid dividend traps. To do that, investors can apply two investment lenses that help reduce the risk inherent in traditional dividend indexes:
The FlexShares Developed Markets High Dividend Climate ESG UCITS ETF is intended to avoid common risks involved with dividend investing by featuring stocks that exhibit high potential to generate income, while avoiding yield traps and unintended sector, region and style biases.
The Fund tracks the iSTOXX® Northern Trust Developed Markets High Dividend Climate ESG Index.1 Northern Trust Global Investments Limited (NTGIL) is the investment manager for FlexShares ETFs. The underlying index is focused on delivering consistent returns and an above-benchmark dividend yield by combining a proprietary view of quality designed to enhance income, along with a holistic approach to sustainability to target an improved sustainability score, a lower carbon footprint and a portfolio, that we believe will be better aligned to manage the transition to a low-carbon economy relative to the benchmark.
Starting with the STOXX Global 1800 Index2, NTGIL first applies a sustainability screen to exclude companies for violations of international norms around environmental, social and governance issues, along with those involved in controversial business lines such as weapons, tobacco and thermal coal. Next, non-dividend paying stocks are excluded, subject to constraints designed to avoid taking excessive individual stock level allocations relative to the STOXX Global 1800.
Working within this screened universe, NTGIL then applies the proprietary Northern Trust Quality Factor to derive a score that we believe measures a company’s core financial health and helps evaluate the financial sustainability of its dividends.
NTGIL evaluates all dividend paying companies in each sector and region across these lenses to calculate each company’s overall quality score. We believe this methodology helps to substantiate an “apples-to-apples” comparison and supports diversification in the index construction process. Then, the stocks in each sector and region are divided into quintiles, with quintile 1 comprising companies with the highest quality scores and quintile 5 comprising companies with the lowest quality scores.
The index eliminates all stocks in quintile 5 (subject to stock level bounds), and then NTGIL applies its proprietary sustainability scoring methodology to assess and rank the remaining stocks. This methodology includes:
NTGIL then constructs the index to include 125-250 stocks that are intended to maximize index’s overall exposure to quality, improve sustainability scores, and enhance dividend yield. The index also applies constraints to maintain sector and regional exposure in line with the original STOXX Global 1800 Index, which helps further bolster diversification and reduce portfolio turnover and transaction costs.
Through ongoing review and monitoring of selected stocks, NTGIL helps maintain the index’s exposure to high-quality dividend paying companies while maintaining its improved sustainability profile. Regular rebalancing also helps maintain the index’s expected risk and return profile.
Dividend investors are navigating a low return environment as well as need to position their portfolios to manage risks and opportunities arising from sustainability issues. We believe these conditions make it increasingly important to identify companies that are likely to maintain or grow their dividends. Our opinion is that investors can benefit from using a multi-dimensional view of sustainability from quality and ESG to identify dividend Payers that can sustain or grow their dividends.
Targeting the intersection between quality and sustainability may help create a portfolio that’s focused on companies that can sustain their dividend payments in the long term and improve risk-adjusted returns. Our analysis suggests that high-quality companies tend to be more profitable, have more conservative balance sheets, and generate higher cash flows—all of which may help protect a company’s dividend relative to lower quality peers.
Similarly, further analysis shows that companies that are sustainability leaders tend to be better at managing risks and opportunities arising from environmental, social and governance themes such as physical climate risk, climate transition risk and regulatory risk. Effective management of these issues may improve the likelihood of sustained long-term profitability, while potentially protecting firms from significant drawdowns in cash flows.
By applying sector and region constraints to maintain similar exposures to the global benchmark, our dividend investing strategy helps avoid unintended concentrations in sectors or regions that have a higher percentage of dividend paying companies. This greater diversification may help support total returns during times when specific sectors or countries strongly underperform the broad global market.
Dividend investing strategies that rely solely on past dividend history to select stocks and that don’t account for the potential impact of sustainability issues can expose investors to higher unintended risks and lower level of a dividend yield of a company than expected. We believe that our holistic, forward-looking approach to assessing financial and non-financial risks can help identify companies that are better positioned to support future dividend payments to meet investor’s objectives.
The FlexShares Developed Markets High Dividend Climate ESG UCITS ETF helps investors avoid common risks of dividend investing by screening and ranking dividend paying stocks for both quality and sustainability. We believe this multi-factor approach offers a quantitative, repeatable methodology for pursuing a dividend investing strategy that emphasizes dividend yields that are high, and likely to be sustainable over the long term.