Quality-Focused Dividend ETFs

Dividend investors have now become increasingly interested in high-quality companies that can provide a consistently-strong earnings performance over time and pay reliable dividend income. These high-quality companies tend to have durable business models and generally possess competitive advantages that result in sustained earnings power that is uncorrelated with the general business cycle dynamics. In fact, high quality is associated with strong moat, high return on invested capital or return on equity, and strong balance sheets. Legendary value investor, GMOs Jeremy Grantham, considers high return, stable return, and low debt as principle indicators of high quality.

In the ETF universe, there are products that allow investors to invest in low-cost portfolios of high-quality companies that are selected based on proprietary models using fundamental factors to evaluate each companys profitability, cash generation capacity, and competitive position. Investing in such factor-driven quality-focused dividend ETFs, dividend investors can achieve instant, low-cost diversification across a number of high-quality companies. Dividends that these ETFs pay rely on individual companies dividend payouts that are considered more reliable and predictable than dividends from many companies of lower quality.

Looking specifically into quality-based dividend ETFs, the iShares High Dividend Equity Fund (NYSE: HDV) stands out. This fund was initiated back in March 2011, and since has returned in excess of 15% annually. It is designed to track the performance of the Morningstar Dividend Yield Focus Index, which comprises of 75 dividend-paying companies that exhibit strong financial health, consistent records of dividend payments, and capacity to sustain above-average dividend payouts in the future. The constituents are selected based on a proprietary screening system that uses the Morningstar Economic Moat and the Morningstar Distance-to-Default as indicators of business quality and financial health. The ETF stocks are weighted in proportion to the total pool of dividends available to investors. The overall portfolio is tilted towards large-cap, value defensive stocks. The overweight sectors are consumer goods (23.60%), healthcare (21.90%), telecommunications (14.63%), and utilities (13.46%). Cyclical sectors, such as financials and industrials, are underrepresented in both the ETF and its underlying index.

This ETF has a 12-month yield of 3.10% and a 30-day SEC yield of 3.17%. It has an average trading volume of about 420,000 units per day. The fund has a beta of 0.94, which is below that of the S&P 500 benchmark. The ETF assesses a gross expense ratio of 0.40%.

Three other U.S.-based quality-focused dividend ETFs come from Northern Trusts FlexShares fund family. Its FlexShares Quality Dividend Index Fund (NYSE: QDF), FlexShares Quality Dividend Defensive Index Fund (NYSE: QDEF), and FlexShares Quality Dividend Dynamic Index Fund (NYSE: QDYN) are developed based on a proprietary quantitative methodology that uses fundamental data to assess the strength and quality of a companys dividend-paying record and prospects. These ETFs debuted in mid-December 2012, offering investors an opportunity to pursue quality-focused dividend investing with reliable dividend income over long-term horizon. All three ETFs have low gross expense ratios of only 0.38% (0.37% on a net basis). (It should be noted that FlexShares also has matching ETFs for non-U.S. stocks.)

FlexShares Quality Dividend Index Fund ETF tracks the price and yield performance of the Northern Trust Quality Dividend Index, applying a proprietary scoring model approach that determines a quality factor and an optimization process that seeks to maximize this factor, match the beta of the Parent Index (Northern Trust 1250) and improve on the Parent Indexs dividend yield. The ETF invests in some 211 securities with a large-cap value tilt, allocating 17.75% of its total weight to financials, 14.61% to IT, and 12.10% to energy. These sectors are expected to lead dividend growth in at least the near future. The funds three largest holdings include Exxon Mobil (NYSE: XOM), Pfizer (NYSE: PFE) and Wells Fargo & Co. (NYSE: WFC). This ETF has a distribution yield of 2.49% and a 30-day SEC yield of 2.96%. Its beta is 1.08, slightly above the markets. This fund has returned 24.12% since its inception on December 14, 2012.

FlexShares Quality Dividend Defensive Index Fund ETF tracks the price and yield performance of the Northern Trust Quality Dividend Defensive Index. The ETF applies a proprietary scoring model approach that determines a quality factor and an optimization process that seeks to maximize this factor, target a beta lower than the Parent Index (Northern Trust 1250) and improve on the Parent Indexs dividend yield. This fund holds a total of 189 securities, with a 60% value weight. The ETF also has the highest weights in financials (17.62%) and IT (14.82%), followed by consumer staples (11.83%). Its three largest holdings include Exxon Mobil, Pfizer, and JPMorgan Chase & Co. (NYSE: JPM). The ETF has a distribution yield of 2.31% and a 30-day SEC yield of 3.01%. Its beta is 0.96. The fund has returned 21.78% since inception on December 14, 2012.

FlexShares Quality Dividend Dynamic Index Fund ETF tracks the price and yield performance of the Northern Trust Quality Dividend Dynamic Index, applying a proprietary scoring model approach that determines a quality factor and an optimization process that seeks to maximize this factor, target a higher beta than the Parent Index and improve on the Parent Indexs dividend yield. This ETF invests in 215 securities, with largest shares allocated to financials (19.76%), IT (14.55%), energy (10.76%), consumer discretionary (10.40%), and industrials (10.03%). Its top three positions are Wells Fargo & Co. Pfizer and JPMorgan Chase & Co. The ETF has a distribution yield of 3.06% and a 30-day SEC yield of 2.90%. Its beta is 1.30, above that of the broad market. This fund has returned 24.82% since inception on December 14, 2012.

As shown above, factor-driven, quality-focused strategies complement dividend-centered investing to create a unique set of dividend ETFs focused on high quality. The aforementioned ETFs represent good examples of dividend ETFs available to those who pursue companies with consistent earnings power over time providing for dividend reliability and sustainability in the future.