August 5, 2013 / 7:26 PM / 4 years ago

COLUMN-Dividend darlings can beat S&P 500 index

By John Wasik

CHICAGO, August 5 (Reuters) - When stock-fund managers beat the market average, often it’s because of a roll of the dice. Skill may come into play, but only rarely.

Sometimes, though, you can think counter-intuitively and come out ahead. Such is the case with high-dividend funds that may avoid loading up on the most glamorous stocks.

Dividends create something of a security blanket around a stock price. In a market selloff, the stocks with the highest market capitalization often get dumped and the dividend payers often stay in portfolios because they promise higher total returns.

To understand why the dividend darling strategy works, you have to look at which companies consistently pay high dividends.

Although above-average dividends are often a sign that a company is in trouble, more often than not they reflect healthy cash flow and future earnings growth. If there are no steady profits, management won’t commit to a dividend that grows on a regular basis.

One smart way to play the dividend game is the ALPS Sector Dividend Dogs ETF, an exchange-traded fund that invests in an index tracking the highest dividend payers in the S&P 500. The name says it all - this fund doesn’t mimic the largest constituents of the S&P, which represent the most popular companies by market value. Instead, it targets lower-profile, less-attractive dividend payers that may offer better stock valuations than their mega-cap cousins.

In theory, a fund like the “Dogs” combines bargain hunting with strong dividends, so you’re not paying top dollar for stocks like MeadWestvaco Corp, a global packaging company; Microchip Technology Inc, which makes semiconductor products; and Leggett & Platt Inc, a diversified manufacturer.

To date, the ALPS strategy has paid off. It’s up 26 percent year-to-date through Aug. 2, beating the S&P 500 index by more than four percentage points. For the year, it’s up more than 31 percent, compared to the S&P’s 28-percent gain.

The fund costs 0.40 percent annually to own - a major trade-off - which is more than 10 times what you’d pay for a garden-variety S&P 500 fund and slightly more than similar funds.

While it’s a relatively new fund, and its market-beating returns are not guaranteed, the strategy has some appeal. ALPS has launched a sister fund - the International Sector Dividend Dogs ETF - that came to market last month.

Another way of approaching the less-popular dividend payers is through an equal-weighted index fund such as the Guggenheim S&P Equal Weight ETF. By assigning equal percentages in its index, the fund eschews the S&P 500 index approach of heavily weighting the most highly-valued stocks.

Instead of big-name stocks like Exxon Mobil and Apple, the Guggenheim fund includes relatively unknown - and often lower priced - mid- and small-cap stocks. Holdings include Micron Technology Inc Hudson City Bancorp Inc and People’s United Financial Inc.

Part of the Guggenheim fund’s stock-selection formula favors dividends. Its annual dividend growth rate is 6 percent, compared to less than 1 percent for the industry. And as with the ALPS fund, these cash-rich stocks have proven to have more upside in a bull market.

The equal-weighting strategy has posted some durable results. The Guggenheim fund has beaten the S&P 500 over the past one-, three-, five- and 10-year periods. It’s gained 36 percent over the past year, besting the S&P by more than seven percentage points. It’s up 24 percent year-to-date.

The only drawback to the Guggenheim fund is its higher annual expenses: 0.40 percent, compared to the Schwab U.S. Large-Cap ETF at 0.04 percent one of the cheapest index funds on the market. Yet the higher fees on the Guggenheim fund more than paid you back in higher performance over time.

The reason why dividends will continue to be important is their contribution to total return. According to Standard & Poor‘s, dividends contributed about one-third of the average monthly total return of the S&P 500 companies from 1926 to 2012.

In times of heady growth, such as the 1990s, most of the return came from capital appreciation. Dividends only accounted for 14 percent of total return in that decade.

But if we’re headed for a slow-growth period in which stocks are only appreciating in the single-digit range, as many pundits predict, then dividends will play an even larger role and dividend darlings will only become more attractive.

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