The better yields on investment-grade bonds that were anticipated in the wake of stronger economic growth and higher interest rates have not yet met the expectations of many income-focused investors. As a result, many of them, particularly retirees, have turned to dividend-paying stocks for additional income opportunities.
This “shift to dividends,” however, has driven valuations for many dividend-paying common stocks to a level where yields are not as attractive as they were during the economic recovery. Some investors have turned to preferred stocks for better yields, but these stocks tend to be concentrated in sectors such as energy production and financials, which can be more vulnerable to economic disruptions, as recently demonstrated in the wake of Hurricanes Harvey and Irma.
Fortunately, global economic growth is creating opportunities for investors to pursue higher dividend yields outside the U.S., with international dividend ETFs serving as effective vehicles for adding the benefits of such an allocation to their portfolios.
Global Growth Pays Dividends
For the first time since 2007, many of the world’s developed and emerging economies are expanding at the same time, according to the Organization for Economic Cooperation and Development (OECD).
In some of these markets, many stable, profitable companies across multiple sectors are paying dividends that are higher relative to those offered by U.S. companies. Yields are higher as well. In 2016 international stocks with dividend yields of 3% or more outnumbered similar U.S. stocks by a 3-1 margin.
Adding these securities to investors’ portfolios not only may increase returns but can also reduce overall volatility and risk by broadening exposure to a larger universe of dividend-paying stocks.
The Challenges of Overseas Investing
Most investors don’t have the knowledge and resources to evaluate the risk-return potential of international equities or the underlying economic and geopolitical factors driving performance in overseas markets.
Global and international mutual funds and ETFs offer an easier, professionally managed alternative. But, most of these funds don’t focus on dividend stocks. And risk concerns compel many fund managers to limit their exposure to emerging markets, where many of the best dividend yields can be found today.
The Solution: Focus on Quality, Wherever it Occurs
At FlexShares ETFs, we believe that the best way to manage the risk of investing in overseas markets is to employ a rigorous, objective due diligence process grounded in the belief that financially healthy companies are more likely to remain reliable dividend payers. We’ve developed such a process—FlexShares’ Dividend Quality Score (DQS) — which enables us to create a universe of stocks that become candidates for our international Dividend Quality indices that serve as benchmarks for FlexShares International Quality Dividend ETFs.
Step 1: Scoring “Quality”
The Dividend Quality Index methodology goes beyond historical valuation and dividend payment records to create a DQS score for a company based on extensive analysis of publicly available financial information. Companies that don’t provide credible financial information (or markets where financial transparency isn’t a priority) aren’t considered.
Each company is rated quantitatively on three financial criteria:
Management efficiency: We evaluate the firm’s use of capital and financing options, with higher ratings for firms that don’t spend aggressively or take on excessive additional financing.
Profitability: We measure the firm’s relative competitive advantages and profit margins, with higher ratings for firms with solid potential for continued earnings growth.
Cash flow: We analyze the firm’s balance sheet and other financial information to assess its liquidity reserves and debt obligations, with lower ratings given to firms that are struggling to pay off debt and meet their daily liquidity needs.
From these separate ratings each company receives an overall DQS score, a measure of investment risk and its likelihood of continuing or growing dividend payments. Stocks with high DQS scores are also ranked on a comparative basis from both a sector and regional standpoint. This helps ensure that firms are compared to similar firms, which results in a highly diversified universe of quality companies representing multiple sectors and countries.
Step 2: Building Diversified International Quality Dividend Indices
From this “quality universe” FlexShares selects equities to populate our three International Quality Dividend indices and the associated FlexShares International Quality Dividend ETFs.
Each index (and ETF) is designed to provide investors with highly diversified exposure to dividend yields in quality companies on both developed and emerging markets.
To prevent geographical or sector over concentration, each index uses proprietary controls and optimization methods to ensure neutral weightings across sectors, countries and regions.
Step 3: Investing for Higher Yields Using FlexShares ETFs
FlexShares three International Dividend Quality Index ETFs employ different strategic beta approaches to address investors’ risk-return preferences:
FlexShares International Quality Dividend Index Fund (IQDF) targets a beta close to the beta of its market universe.
FlexShares International Quality Dividend Defensive Index Fund (IQDE) targets a beta that is less than that of its market universe.
FlexShares International Quality Dividend Dynamic Index Fund (IQDY) targets a beta that is greater than that of its market universe.
Income-focused investors who only hold U.S. dividend-paying equities may be missing out on the higher dividend yields available from financially healthy companies in overseas markets. Adding an allocation to FlexShares International Quality Dividend ETFs offers investors access to these additional sources of yield, while its neutral sector and market weightings provide the risk-management benefits of a broadly diversified portfolio of dividend stocks.
Abdur Nimeri is a Senior Investment Strategist for FlexShares Exchange Traded Funds (ETFs), focusing on ETF strategy and product development.
Before investing, carefully consider the FlexShares investment objectives, risks, charges and expenses. This and other information is in the prospectus and a summary prospectus, copies of which may be obtained by visiting www.flexshares.com. Read the prospectus carefully before you invest.
Foreside Fund Services, LLC, distributor.
An investment in FlexShares is subject to numerous risks, including possible loss of principal. Fund returns may not match the return of the respective indexes. The Funds are subject to the following principal risks: asset class; commodity; concentration; counterparty; currency; derivatives; dividend; emerging markets; equity securities; fluctuation of yield; foreign securities; geographic; income; industry concentration; inflation-protected securities; infrastructure-related companies; interest rate / maturity risk; issuer; large cap; management; market; market trading; mid cap stock; MLP; momentum; natural resources; new funds; non-diversification; passive investment; privatization; small cap stock; tracking error; value investing; and volatility risk. A full description of risks is in the prospectus.
FlexShares International Quality Dividend Index Fund (IQDF), FlexShares International Quality Dividend Defensive Index Fund (IQDE) and the FlexShares International Quality Dividend Dynamic Index Fund (IQDY) are passively managed and use a representative sampling strategy to track their 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. 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 at increased risk of industry concentration, where it may be more than 25% invested in the assets of a single industry. The Funds may be more susceptible to adverse economic, market, political or regulatory occurrences affecting that country, market, industry, sector or asset class. Finally, the Funds may also be subject to increased volatility risk, where volatility may not equal the target of the underlying index. See prospectus for a full description of risks.
i. Josh Zumbrun, “Global Economies Grow in Sync,” The Wall Street Journal, August 23, 2017.
ii. Dividends represent past performance and there is no guarantee they will continue to be paid.