Dividend Growth ETFs can be meaningful for long term investors

ETFs or exchange traded funds are investment vehicles that work like mutual funds but have a funding structure that resemble that of stocks. These ETFs raise funds from capital markets like companies raise capital and use these funds to make stock market investments in order to deliver growth of capital or income or any other chosen theme. The performance of an ETF is generally tied to that of a chosen index and the units of an ETF are traded in the stock markets just like shares of a company. An ETF can have many themes or styles, depending on what the investors or investment managers want to achieve.

One of such themes or styles of investing is dividend income theme. This ETF invests in dividend paying stocks and targets dividend income as its main sources of income; it tries to make a smaller number of transactions so that it may save on transaction and brokerage costs. Owing to these characteristics this style or strategy is often regarded as a passive strategy, and its returns are often inferior to that of actively managed funds. This type of fund is most suitable for investors with a low risk profile and in need for a current stream of income. Within this strategy however, there is still some scope to build a semi passive, growth-oriented fund which can not only deliver on a long-term growth of capital but also provide enhanced dividend yields to the investors.

In a dividend strategy it is of paramount importance that the fund manager chooses stocks which have a consistent dividend track record and belong to well-established companies having track records of robust financial performance. Such companies are generally mid-lifecycle stage companies, belonging to established business sectors and which do not have significant growth opportunities ahead. They have a large corpus of surplus funds with no current productive employment opportunities. It is in part to sustain investor interest in the company and partly to arrest the falling rate of return on capital employed, that the management gives away a portion of the company’s earnings as dividends. Given these characteristics of such companies, it ensues that they would face limited business risks and are also least effected by any adverse macroeconomic headwinds. Investment in stocks of such companies is thus highly defensive and provides limited upside potential to the investors. Having such stocks in a portfolio thus will not deliver much on the capital gain front while deriving a good current income and providing high safety to the capital invested. This strategy is thus useful to investors who have a large corpus of funds are not interested in growth and would rather enjoy a good current income.

However, there is more to this strategy. This can be transformational in order to deliver long-term growth analogous to an actively managed growth fund while still operating within the limits of safety of a passively managed fund. There are stocks which are just emerging out of their early growth phase and are fast establishing themselves in their sectors. Â Such companies have either commenced or would begin to pay dividends and that too at an incremental rate for a few initial years before the dividends stabilize. A fund manager may be able to identify such stocks and invest in them keeping a long-term horizon. Also, an investor, while in early stages of his life, would be in a position to part with a portion of his current income and invest in such a fund so that he may get an enhanced yield when he needs it in the later part of his life. Hence such an investor may want to redeploy his dividend income and purchase more such securities. A dividend growth ETF combines these two things; while it invests in currently growing companies which are expected to pay good dividends and redeploys these dividends in purchasing more securities for a long term horizon rather than paying them off. This strategy, though semi passive, does not involve as much churning of portfolio as that of an active fund and is less expensive while on the other hand it has the potential to deliver returns in the medium to long term which may not only surpass the returns generated by an actively managed fund but may do so with a risk profile that is consistently below that of an actively managed fund.

This type of an ETF has other type of advantages to that of an actively managed ETF as well. These funds while consistently investing in dividend paying mid- to- low risk stocks have less overall volatility and are much better placed to withstand adverse economic conditions and preserve investors’ wealth. The consistent redeployment of funds increases the rate of return earned by the investor, meaning that the return earned every year by the investor is the rate of return declared by the company multiplied by the incremented capital base which is the result of the dividend redeployment from prior years. These funds are able to successfully utilize time as a factor to bring down the risk associated with investments and in the long run the investor not only realizes decent capital gains but also a current income that is far superior to a traditional pure passive dividend ETF. The above is a powerful long-term growth strategy. It has the potential to not only surpass the both active and passively managed funds in terms of returns but also acts as protector of investor wealth.

The investor profile for such a fund are people who have a long term investment timeframe, are willing to part with the dividend income in the short run in order to fund long term growth of their fund while not intending to take as much risk as that assumed by an actively managed ETF. The performance of this type of fund mimics a forward inclining curve, which in the initial years would seem to underperform but will slowly and steadily rise and in time to surpass the returns generated by other comparative funds.  An actively managed fund may exhibit a superior performance in the near term, but its growth may stagnate in the medium to long term.