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A Suite Approach to U.S. Quality

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Dividend-paying stocks have long contributed to investors’ total returns and served as a source of potential income from an investment portfolio. We believe successful dividend investing requires a careful approach: one that pursues attractive yields while avoiding the risks associated with dividend investing.

In this paper, we offer a closer look at some of those risks. We then explain the methodology of the underlying indices that the three FlexShares ETFs within the U.S. Quality Suite including the FlexShares Quality Dividend Index Fund (QDF), the FlexShares Quality Dividend Defensive Index Fund (QDEF) and the FlexShares Quality Dividend Dynamic Index Fund (QDYN), track in an attempt to invest in stocks with dividend yields1  that are both high and sustainable while taking a three different approaches to the U.S. equity market.

THE CHALLENGES OF DIVIDEND INVESTING

For decades, investors have looked beyond price appreciation to stock dividends as another source of return in their equity portfolios. In recent years, persistently low interest rates have made dividend income even more valuable as investors have sought an income-producing alternative to traditional fixed-income investments.

As dividend income becomes more important to investors’ overall portfolios, it’s critical to avoid common risks that can threaten their dividend income stream. It can be tempting to simply choose stocks with the highest dividend yield in an effort to boost a portfolio’s total return and income potential—but those high yields may come with higher risks.

Primarily, investors must avoid so-called “dividend traps.” High dividend yields often result from falling stock prices, either due to company-specific financial challenges or to broader market or macroeconomic threats. Those problems may cause companies to reduce or suspend their future dividends, undercutting the expected benefit investors look for from dividend-paying equities. What’s more, dividend-paying stocks may be concentrated in specific sectors and industries, so focusing on them may lead to portfolios that are under-diversified and overweight in those particular areas.

In our view, the key to successful dividend investing is to focus not just on high dividend yields, but on sustainable dividend yields—in other words, dividend payments that are likely to continue in the future.2 To do that, investors should consider a two-pronged approach:

Chart-A two-pronged approach

THE FLEXSHARES SOLUTION: MEASURING DIVIDEND QUALITY IN EVERY MARKET SECTOR

All three funds that comprise the FlexShares U.S. Quality Suite are ETF’s that seeks to avoid common risks associated with dividend investing by tracking a custom index. Northern Trust Investments Inc. (NTI) is the investment adviser for FlexShares ETFs.

Each index starts with the Northern Trust 1250 Index3, which represents 1,250 large and mid-capitalization U.S. public companies, NTI first eliminates all non-dividend paying stocks. Then, they apply a proprietary, multi-faceted Dividend Quality Score (DQS) to measure a company’s core financial health and evaluate whether it may increase (or decrease) its future dividends.

Chart - THE DQS METHODOLOGY

The DQS score evaluates dividend-paying equities across all these lenses and ranks companies in each sector. This approach helps ensure an “apples-to-apples” comparison because different financial characteristics may be appropriate in different sectors. It also identifies quality companies in every sector, supporting diversification in the initial index construction process.

NTI ranks all stocks in a sector by DQS score and divides the list into quintiles, with quintile 1 comprising the highest-ranked companies and quintile 5 comprising the lowest-ranked firms. The index eliminates all stocks in quintile 5, and then diversifies holdings according to rules such as maximum overweights / underweights for individual stocks, sectors and industries.

Sidebar chart - Targeted Beta

HARNESSING QUALITY AND YIELD FOR GREATER CONFIDENCE

While dividend investing is a well-established equity investment strategy, blindly pursuing stocks with the highest dividend yields may be dangerous in the long run. High dividend yields may mask underlying problems—such as weak stock prices due to poor financial performance—that could result in lower future dividend payments.

The FlexShares Quality Dividend suite of funds helps investors avoid common risks of dividend investing by selecting stocks with both high dividend yields and strong underlying fundamentals. We believe this suite of quality-focused funds offers investors several choices to consider in pursuing a dividend investing strategy that emphasizes sustainable dividend yields to help meet their goals for income and total return.

CONCLUSION

While dividend investing is a well-established equity investment strategy, blindly pursuing stocks with the highest dividend yields may be dangerous in the long run. High dividend yields may mask underlying problems—such as weak stock prices due to poor financial performance—that could result in lower future dividend payments.

The FlexShares US Quality Dividend suite of funds helps investors avoid common risks of dividend investing by selecting stocks with both high dividend yields and strong underlying fundamentals. We believe this quality-focused approach offers a method for pursuing a dividend investing strategy that emphasizes sustainable dividend yields to help meet investors’ goals for income and total return.


Footnotes

1 Dividend yield is a financial ratio that indicates how much a company pays out in dividends each year relative to its share price. Dividend yield is represented as a percentage and can be calculated by dividing the dollar value of dividends paid in a given year per share of stock held by the dollar value of one share of stock.

2 Dividends represent past performance, and there is no guarantee they will continue to be paid.

3 The Northern Trust 1250 Index is designed to provide broad-based exposure to the U.S. equity markets, with a bias toward large and mid-capitalization companies. In an effort to include a greater number of dividend-paying companies, a constituent limit of 1250 is used at the time of each annual reconstitution.

4 Beta is a statistical measure of the volatility, or sensitivity, of rates of return on a portfolio or security compared to a market index. The beta for an ETF measures the expected change in return of the ETF relative to the return of a designated index. By definition, the beta of the Standard & Poor’s (S&P) 500 Index is 1.00. Accordingly, a fund with a 1.10 beta is expected to perform 10% better than the S&P 500 Index in rising markets and 10% worse in falling markets.

5 Northern Trust Quality Dividend Index tracks a portfolio of long-only U.S. equity securities, with an emphasis on long-term capital growth and a targeted overall beta that is similar to that of the Northern Trust 1250 Index.

6 The Northern Trust Quality Dividend Defensive Index is designed to provide exposure to a high-quality income-oriented portfolio of long-only U.S. equity securities, with an emphasis on long-term capital growth and a targeted overall beta that is generally between 0.5 to 1.0 times that of the Northern Trust 1250 Index.

7 The Northern Trust Quality Dividend Dynamic Index is designed to provide exposure to a high-quality income-oriented portfolio of long-only U.S. equity securities, with an emphasis on long-term capital growth and a targeted overall beta that is generally between 1.0 to 1.5 times that of the Northern Trust 1250 Index.


FIND OUT MORE

The FlexShares approach to investing is, first and foremost, investor-centric and goal oriented. We pride ourselves on our commitment to developing products that are designed to meet real-world objectives for both institutional and individual investors. If you would like to discuss the attributes of any of the ETFs discussed in this report in greater depth or find out more about the index methodology behind them please don’t hesitate to call us at 1-855-FlexETF (1-855-353-9383).


FlexShares Quality Dividend Index Fund (QDF), FlexShares Quality Dividend Defensive Index Fund (QDEF) and the FlexShares Quality Dividend Dynamic Index Fund (QDYN) are passively managed and use a representative sampling strategy to track its underlying index. Use of a representative sampling strategy creates tracking risk where the Fund’s performance could vary substantially from the performance of the underlying index along with the risk of high portfolio turnover. Additionally, the Funds are at increased dividend risk, as the issuers of the underlying stock might not declare a dividend, or the dividend rate may not remain at current levels. The Funds are also is at increased risk of industry concentration, where it may be more than 25% invested in the assets of a single industry. Finally, the Funds may also be subject to increased volatility risk, where volatility may not equal the target of the underlying index.