Director of ETF Product Development Brandon Rakszawski explores the demand for income-producing assets and Morningstar’s durable approach to dividend investing, which seeks high-yielding, financially health companies with attractive valuations.
Income Investing Trends
BRANDON RAKSZAWSKI: After a brief stint of tightening, the Fed is now back in easing mode. Interest rates have declined, which add to what has been a decade plus search for yield for investors. I think that that need for income paired with some apprehension in the markets in 2019 led to ETF fixed income flows surpassing all-time highs in terms of net new inflow in 2019. It nearly kept pace with equity ETFs in terms of total net flows for the year, despite equity markets posting returns of 30% plus here in the U.S. So, certainly a demand for income-producing assets.
RAKSZAWSKI: Longer term, we've seen what used to be previously obscure asset classes become far more prominent in many investors’ portfolios. So certain asset classes focused on income such as MLPs—master limited partnerships. Mutual funds and ETFs in the U.S. investing in that space have grown over 800% in the last decade; infrastructure funds, mutual funds and ETFs, 700%; preferred securities, 300%; real estate, 200% in the last decade. So, it clearly trends toward income-producing assets. Dividend-focused ETF strategies are no exception. ETFs that allocate to dividend-paying stocks have grown from a very small $12 billion segment of the ETF market prior to the financial crisis of 2008 to about $230 billion today. So clearly long- and short-term trends toward income bearing assets.
Durable Approach to Dividend Investing
The VanEck Vectors Morningstar Durable Dividend ETF, ticker D-U-R-A, or DURA, seeks to leverage Morningstar's equity research process, their forward looking equity research process, to assemble a portfolio of high-yielding companies that are financially healthy and also focus on valuations. The underlying index of the ETF, the Morningstar US Dividend Valuation Index, uses a three-pronged approach. It starts with the obvious, target companies with high dividend yield. And then it ensures that a company is financially healthy, which is very important. And third, it allocates to those high yielding financially healthy companies that also display attractive valuations.
Financial Health Check
The strategy assesses financial health using Morningstar's distance-to-default score. Distance-to-default is a quantitative measure that's used to assess the probability that a company may default or go into bankruptcy. Distance-to-default considers both financial statement information, such as asset values and total liabilities, but also recent equity market data, namely equity price volatility associated with a company. The reason that the model considers equity market data is that equity markets tend to be, or can be, a leading indicator of financial distress, sometimes indicating financial distress in a company far before any financial statements may reflect that stress, or even credit rating agencies may reflect financial distress in a credit rating. So, the distance-to-default score is not only a quantitative measure of financial health, it's important because it's predictive in a forward looking way. Morningstar has found that distance-to-default is a strong indicator of the potential for future dividend cuts from a company.
RAKSZAWSKI: In other words, a company with better financial health, or a longer or larger distance to default has historically had less of a chance of cutting future distributions. A great case study on how this has played out in the underlying strategy would be Kraft Heinz. In 2018, the company was a member of the Morningstar US Dividend Valuation Index. In September of that year, the company was removed from the index because it failed the index's distance-to-default screen. Subsequently in February of 2019 Kraft-Heinz cut its distribution significantly, and its market price sold off to a pretty large degree. So, the distance-to-default screen allowed this strategy to flag potential for future dividend cut and remove that company from the index and avoid holding Kraft Heinz at the time of its dividend cut.
Tremendous asset flow into dividend-paying stocks, paired with equity markets reaching all time high seemingly every week elevates the importance of focusing on valuations when accessing the equity markets. Morningstar's rigorous forward looking valuation process forecasts future free cash flows decades into the future, discounting them back and arriving at a current intrinsic value. The underlying index can then leverage that research to ensure that the strategy on a regular basis, at each review, is avoiding overpaying for dividend-paying stocks. This is what truly sets DURA apart from other indexed dividend strategies.
Distance to Default Score: A structural or contingent claim model that takes advantage of both market information and accounting financial information to determine the expectation that default will occur.
Morningstar® US Dividend Valuation IndexSM: is designed to provide exposure to securities in the Morningstar US Market Index that have high dividend yield, strong financial health, and attractive uncertainty adjusted valuation.
Index returns assume reinvestment of all income and do not reflect any management fees or brokerage expenses associated with fund returns. An index's performance is not illustrative of a fund's performance. You cannot invest directly in an index.
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