Scott Kubie has been using dividend-focused exchange-traded funds for several years. But recently he thinks these vehicles, which focus on dividend-rich pockets such as U.S. utilities, have become over-mined territory.

“Investors have been buying high-dividend stocks as a substitute for bonds, even though they’re clearly not,” says Kubie, the chief investment strategist of CLS Investments. “The big question is whether or not people are overpaying for high dividends. And in a lot of cases the answer is yes.”

Because dividends have historically accounted for about 40% of total stock market returns, they’re still an important part of his investment strategy. But there’s a difference between funds that simply offer the highest yielders and those whose companies can show dividend growth at a healthy clip. Kubie is now focused on the latter.

The high yielders are typically utilities and industrials. They are more sensitive to interest rates than most stocks—doing better than the market when rates fall and worse when they rise. Dividend growers, by contrast, come from “growthier” industries such as technology, health care and consumer goods. Although they yield about the same or slightly higher than the overall market, they can grow dividends faster because they benefit from strong cash flow and growing earnings. These traits make them less sensitive to interest rates than other high-dividend stocks.

Dividend Growth
The dividend growers have characteristics that help during slow economic growth, says Tyler Mordy, president of HAHN Investment Stewards.

“I think investors will be willing to pay a premium” for such businesses, he says. “The companies also have better growth potential than those that pay the highest dividend because they can use their cash for other purposes, such as acquisitions.”

The biggest dividend growth ETF, one favored by both Kubie and Mordy, is the $20 billion Vanguard Dividend Appreciation fund (VIG). It has a low 0.10% expense ratio, holds companies that have raised their dividends every year for at least the last 10 years and uses screens to weed out businesses that look vulnerable to dividend cuts in the future. Its largest sector exposure is industrials (23%), followed by consumer goods (19%) and consumer services (15%).

With a yield slightly below that of the S&P 500, this clearly isn’t a pure dividend play. Instead, the ETF and others like it use a history of rising dividends and other screens to pinpoint companies with low leverage, high profitability and other quality characteristics that help them stay up in rising markets and weather tougher times.

The recipe worked well for VIG during 2008, when it fell only 27% while the S&P 500 was falling 36%. Over the last five years, the fund has captured 87% of the market’s upside and 86% of its downside with less volatility.

The three-year-old, $2 billion Schwab U.S. Dividend Equity ETF (SCHD) isn’t advertised as a dividend growth offering, though it certainly resembles one. The fund seeks high-quality large-cap companies screened for their cash flow, debt, return on equity, dividend yield and dividend growth. These companies should have paid dividends for at least 10 consecutive years. The largest sector in the fund is consumer staples, representing 22% of assets, followed by industrials with 16% and information technology and energy at roughly 13% each. The fund has a razor-thin expense ratio of just 0.07%, making it the cheapest dividend ETF around.

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