Beyond High Yields: The Case for Dividend Growth and Active Management in Today's Market

However, investors may want to rethink that stance.

It turns out that dividend growth could be the winner over the long term. And it’s here that active management can play a big role in finding the best dividend growth names and durability of payout strength. The best part is that active ETFs have continued to drive the active advantage even further.

Today, getting 5%+ out of bonds is still an easy task. The higher interest rate environment has pushed up yields on all sorts of fixed-income assets. Today, you can easily get a high livable yield from cash and T-bills.

With that, dividend seekers have been left cold. Equity risk makes many dividend stocks, and their comparatively low yields, a losing proposition. To compensate for this, many dividend seekers have started to migrate into higher yielding stocks and sectors. By focusing here, many investors feel like they are getting a better deal and are being adequately compensated for the additional equity risk versus the safety of bonds.

However, that might not be the best strategy for the long term. A high starting dividend yield may not be the best solution to generating income for the longer term. Dividend growth matters more.

The proof is in the data and returns. Just take a look at the below chart comparing the S&P 500 Dividend Aristocrats,an index of dividend growers, versus the Dow Jones U.S. Select Dividend Index,a benchmark of the highest yielding firms. As you can see, the outperformance of dividend growers is clear.

Source: Proshares

The question is why?

One of the answers lies within quality. Investors like bonds due to their lower overall risk. There’s pretty much a zero chance that the U.S. government will default on its debt, or the State of Texas won’t be able to make its interest payments. However, that sort of guarantee doesn’t apply to high-yielding stocks. In fact, it tends to be the opposite.

High dividend yields are often a result of increased risk. Many stocks that offer significantly higher-than-average dividends usually do so for a reason. This could be due to declining cash flows, financial losses, legal issues, or overall business difficulties. As investors sell off these shares, the yields rise, and those who continue to hold them expect “more cash up front” to compensate for the heightened risk. Additionally, these stocks typically have weaker financial conditions.

According to S&P Global, this shows up in debt-to-equity and return-on-equity ratios. For example, the S&P High Yield Dividend Aristocrats had a long-term debt-to-equity ratio of 40.4% compared to the 42.2% for the S&P Composite 1500 and 49.6% for the S&P 500 High Dividend Index. ROE calculations are similar, with the dividend growers coming ahead. ¹

This plays into the quality aspect of many dividend growers, which eventually drive their total returns.

The problem is, not all high-yield stocks are “garbage.” Separating the wheat from the chaff is nearly impossible when it comes to indexing. Afterall, the main reason investors choose passive management is because these funds tend to own everything. But in the case of dividend growth investing that’s not a great idea.

Active managers can perform due diligence and research to determine whether or not a better-than-average yield is a cause for a concern. Moreover, focusing on business trends, sales, moats, credit quality and other trends can help uncover dividend-growth opportunities, values and quality all along the yield spectrum. According to Morningstar, this allows active managers the ability to “combine dividend yield with dividend growth to build a more robust and balanced portfolio of complementary dividend stocks to smooth out returns

Here again, the proof is in the pudding. Actively managed dividend funds have managed to outperform their passive peers over the last 3- and 5-year periods.

Perhaps, the best part is that ETFs are pushing the favor towards active dividend management, because ETFs are able to exploit some of the best features of dividend investing.

First are taxes. The ETF structure provides plenty of tax advantages when it comes to dividend investing. The creation-redemption mechanism is a wonderful thing for investors, allowing ETFs to pass away capital gains via in-kind transactions. When a fund manager chooses to exit a position, investors won’t bear the tax consequences of that decision. Short-term capital gains can be particularly detrimental to portfolios, diminishing the tax advantages of dividend investing.

The structure plays into the total return aspect and better income potential for dividend-growth investing versus a high-yield investing strategy. Because investors can control their own capital gains, only when the ETF is sold, they can balance their own tax liabilities and help produce long-term capital gains, which are taxed at lower rates. In fact, some investors may be able to pay zero taxes on their sales and dividends depending on their income. This could be a real win for investors in retirement.

So, with better outperformance, the ability to generate lower taxes and less risk, it makes sense to go active with dividend ETFS and skew towards dividend growth. Luckily, there are plenty of ways to do just that.

These ETFs were selected based on the exposure to dividend stocks with an active touch. The list is sorted by their year-to-date returns, which ranges from 6% to 20%. They have expense ratios between 0.33% and 1.97% and assets under management of $8M to $7B. They are currently yielding between 1.5% and 12.6%.

Overall, active management is a clear winner when it comes to finding dividend growth and portfolio opportunities. Investors should consider using active management over simply focusing on a high yield. Better long-term outperformance and tax advantages await.

Investors looking at dividends have been drawn towards high yields to match the current bond environment. However, dividend growth and its lower yields are a better bet. The best part is that active ETFs help exploit all the advantages of this fact.

¹ S&P Global (June 2024). A Case for Dividend Growth Strategies