ETF Central's Ultimate Guide to Dividend Investing, Part 4: Dividend Quality ETFs

What is Dividend Quality?

Dividend quality refers to the sustainability and reliability of a company's dividend payments. While high yields and consistent growth are attractive, the true measure of a dividend's quality is its ability to be maintained through various economic cycles.

High-quality dividends are typically supported by strong fundamentals, and several metrics can help investors assess dividend quality:

1. Payout Ratio: The percentage of earnings paid out as dividends. A lower payout ratio indicates that a company retains more of its earnings, providing a cushion to maintain dividends during downturns.
2. Earnings Stability: Companies with consistent and stable earnings are more likely to sustain their dividend payments.
3. Cash Flow Adequacy: Adequate free cash flow ensures that a company can cover its dividend payments without relying on debt or other financial manoeuvres.
4. Debt Levels: Companies with lower debt levels are less likely to cut dividends in times of financial stress.

Why should you care about dividend quality?

Simply put, if you rely on dividends for income, a cut in dividend payments can be a significant setback or change your investment thesis altogether.

Dividend cuts can severely impact your cash flow, especially if you are using those dividends for living expenses or reinvesting them for compound growth. Ensuring the dividends you receive are from companies with strong fundamentals helps mitigate this risk.

Dividend cuts are not just a theoretical concern; they have happened to some of the most renowned companies. General Electric, once a blue-chip stalwart, drastically reduced its dividend in recent years due to financial struggles.

Even "Dividend Kings" like 3M, which had over 50 years of consecutive dividend growth, have faced challenges leading to dividend cuts. These examples underscore the importance of thoroughly evaluating the quality of a company's dividend to ensure it is sustainable over the long term.

In essence, evaluating dividend quality is a critical due diligence step. It's not enough to find a stock or ETF with attractive yields and growth; ensuring the underlying dividends are sustainable protects your income stream and investment returns.

How do ETFs target dividend quality?

The metrics listed earlier are pretty universal but also elementary. ETFs have a ton of leeway to implement these or choose different screeners altogether when it comes to dividend quality.

For example, consider the Global X S&P 500 Quality Dividend ETF

. This ETF takes the top 200 companies in the S&P 500 based on dividend yield and a composite quality screener consisting of return-on-equity, accruals, and financial leverage.

Then there's a duo from FlexShares: the FlexShares Quality Dividend Index Fund

and the FlexShares Quality Dividend Defensive Index Fund

QDEF

. Both target U.S. dividend stocks screened for profitability, solid management, and reliable cash flow.

However, there's a difference: QDEF also includes a low-volatility screen to ensure that the overall beta is generally between 0.5 to 1.0 times that of the Northern Trust 1250 Index. This actually makes it a hybrid dividend ETF, which will be the focus of the next part in this series.

But back to quality dividend ETF methodologies—each provider can have a unique approach. We've seen how FlexShares and Global X differ, and now we'll take a look at ALPS with the ALPS O'Shares US Quality Dividend ETF

.

This ETF targets mid and large cap U.S. dividend stocks, and the quality screen employed checks specifically for profitability via ROA, leverage via net debt to EBITDA, and dividend coverage.

But again, it really is more of a hybrid approach—it also requires 5-year dividend growth and low volatility via a 5-year weekly standard deviation screen.

The point is—dividend quality is hardly ever targeted in isolation. More commonly, you'll see it used in conjunction with dividend yield and growth screens. Unsurprisingly, part 5 of this series will focus on these hybrid dividend ETFs, so stay tuned for it!

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.