ETF Central's Ultimate Guide to Dividend Investing, Part 3: Dividend Growth ETFs

Why dividend growth?

Like anything money-related, dividends are susceptible to the invisible killer of value—inflation. Inflation erodes the purchasing power of money over time, meaning that the same amount of money buys fewer goods and services in the future than it does today.

This erosion applies to dividends as well. If a company's dividends do not grow at least as much as inflation, the real value of those dividends decreases over time.

For instance, if inflation is running at 2% per year, a company needs to increase its dividend by at least 2% annually to maintain the purchasing power of those dividend payments.

Without this growth, the dividends' ability to support your financial goals—whether that's providing income in retirement or reinvesting for future growth—diminishes.

This growth is even more critical if you're reinvesting those steadily growing dividends. Reinvesting dividends means using the dividend payments to purchase additional shares of the company. As time goes on and the company continues to grow its dividends, those reinvested dividends buy more shares.

Those new shares, in turn, produce more dividends, creating a powerful compounding effect. The snowball keeps rolling and growing, leading to an increasingly larger stream of income over time.

How do ETFs target dividend growth?

The most common and straightforward way ETFs target dividend growth is by setting criteria for how many years historically an eligible holding must have consecutively increased dividends. This approach ensures that the selected companies have a proven track record of returning value to shareholders.

For example, the S&P U.S. Dividend Growers Index, tracked by the Vanguard Dividend Appreciation ETF

, requires companies to have increased their dividends for at least 10 consecutive years.

Similarly, the iShares Core Dividend Growth ETF

, which tracks the Morningstar US Dividend Growth Index, requires a minimum of five years of consecutive dividend growth.

The beauty of this criteria is that it can be easily complemented by other screeners, whether for high dividend yield or dividend quality. These hybrid dividend ETF strategies will be discussed in a future article in this series.

But back to dividend growth—you may have heard of names like "dividend aristocrats" and "dividend kings" used for stocks with even higher streaks of unbroken dividend growth.

For example, the ProShares S&P 500 Dividend Aristocrats ETF

equally weights a selection of S&P 500 stocks with at least 25 years of unbroken dividend growth.

Taking this even further, the Roundhill S&P Dividend Monarchs ETF

selects stocks from the S&P Composite 1500 Index with at least 50 years of consecutive dividend increases.

The benefits of dividend growth ETFs

The yields on dividend growth ETFs aren't going to excite income investors. While these ETFs usually offer higher yields than broad market index benchmarks like the S&P 500, they don't reach the 3-5% yields seen with high-yield dividend ETFs.

So, why own these ETFs? As Vanguard found, they are a great way to target quality stocks inexpensively, albeit with a focus on just the dividend-paying ones (sorry, Berkshire!).

We can break down the source of a company's "quality" into two Fama-French factors. Just like how high-yield dividend ETFs can provide exposure to the value (high minus low, or HML) factor, dividend growth ETFs can provide exposure to:

• Profitability (RMW, or robust minus weak): This factor measures the performance of stocks with robust (high) profitability versus those with weak (low) profitability. Dividend growth companies tend to have strong and consistent earnings, which support their ability to increase dividends over time.
• Investment (CMA, or conservative minus aggressive): This factor evaluates the return differences between companies that invest conservatively and those that invest aggressively. Dividend growth companies typically follow a conservative investment strategy, focusing on steady, sustainable growth rather than aggressive expansion.

Dividend growth companies often have above-average exposure to these two factors due to their traits. They generally exhibit strong and stable earnings (profitability) and prefer steady, measured investment approaches (conservative investment), which aligns well with the characteristics sought by investors targeting quality.

A factor regression analysis illustrates this concept. As seen below, even though it is not an explicit quality factor ETF, DGRO has historically provided higher loadings to both the profitability and investment factors compared to the brand-name iShares MSCI USA Quality Factor ETF

.

This being said, dividend growth ETFs indirectly target quality. But you can also directly target dividend quality, which focuses more on how sustainable the dividend is versus how long it has grown historically. For this, stay tuned for Part 4 of this series soon.

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.