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 Dividend is a hot word on Wall Street these days. Once considered boring and stodgy, dividend-paying stocks are enjoying renewed attention from investors. It is not hard to see why, considering the bear market that ushered in the new millennium, historically low bond yields and Congress' 2003 decision to give favorable tax treatment to dividends. Another advantage is best illustrated by the old adage that a bird in the hand is worth two in the bush-a paid dividend secures a decent chunk of total return, regardless of what happens to share price.
Along with the heightened interest in dividends has come a spate of new investment products offering investors exposure to income-producing stocks. As enthusiasm for equity-income investing has grown, so too has the need for corresponding indexes and benchmarking tools. Typically, investors have had to rely on the S&P 500 Index, or more recently the Russell 1000 Value Index, as benchmarks for equity-income strategies. The fit, however, is tenuous, as neither index specifically focuses on the dividend-paying stocks driving portfolio managers' strategies. To fill this gap, a number of dividend indexes have been introduced in recent years. In focusing on dividends, however, several of these indexes have strayed from some established principles for what constitutes a good index. In this paper, we review the principles for building effective indexes and explore how they can best be applied when constructing dividend indexes.
Back To Basics
In recent years, indexing has become increasingly complex, with thousands of indexes in every shape and size serving every sort of purpose imaginable. The two primary applications of indexes are:
1) To serve as benchmarks for actively managed funds; and,
2) To provide investable portfolios for index funds (Siegel, 2003).[2]
Scholars over the years have identified various criteria that enable indexes to effectively fulfill these basic purposes. To be effective as a benchmark, for example, an index should be a passive representation of a manager's investment process, incorporating the prominent and persistent characteristics of a manager's portfolio in the absence of active management. In other words, the benchmark should contain those securities from which the manager typically selects, weighted in a manner consistent with the manager's investment process (Bailey, 1992). Generally, the more complete the benchmark-the broader and deeper its coverage-the more effectively it represents a manager's universe (Schoenfeld and Ginis, 2004).
When an index is to be used as a portfolio for index funds, additional criteria apply. In general, the indexes should be:
- Market-cap weighted. Market-cap weighting is widely considered to be the central organizing principle of good index construction. It is usually implemented with a "float" adjustment, which subtracts the number of closely held and illiquid shares from the number of shares outstanding. The advantage of market-cap weighting is that the weights adjust automatically as share prices fluctuate, eliminating the need for the frequent and expensive rebalancing that can occur with other weighting schemes (Platt, Pope and Rakvin, 2004). Moreover, a float-adjusted, market-cap-weighted portfolio is macroconsistent, meaning that if all investors held such a portfolio, all available shares of its constituent stocks would be held with none left over. With all other weighting schemes, it is mathematically impossible for all investors to hold the index portfolio (Siegel, 2004).
- Investable. It is important that an index represent an investable set of constituents and a viable investment alternative (Platt, Pope, and Rakvin, 2004). In other words, an index fund must be able to replicate the index without undue liquidity concerns.
- Low turnover and related transaction costs. To keep transaction costs to a minimum, an effective index should not require excessive turnover. This is particularly important as the market is divided into smaller segments, because turnover can have a greater impact on a more concentrated constituent base.
Applying The Principles
We now turn to the question of how well the principles of index construction have been applied to dividend-based investment strategies. In the past, equity-income managers have had to rely primarily on the S&P 500 to benchmark their funds. In fact, among equity-income funds that list benchmarks in their prospectuses, four out of five use the S&P 500, while the rest use the Russell 1000 Value Index. Unfortunately, neither reflects very accurately the way these dividend-oriented managers invest. For example, both the S&P 500 and the Russell 1000 Value contain many stocks that do not even pay dividends.
To meet the needs of dividend-seeking investors, several new indexes have been launched in recent years. These include the Dow Jones Select Dividend; Mergent Broad Dividend Achievers and Mergent Dividend Achievers50; and the S&P Dividend Aristocrats and S&P High-Yield Dividend Aristocrats indexes. By focusing on dividend-paying stocks, these indexes more closely mirror the investment style of equity-income managers. In so doing, however, they end up straying from some of the other principles of index construction:
- By focusing on relatively few stocks, many of these indexes are too narrow to effectively represent a manager's investment universe.
- By disregarding market cap and weighting instead by dividend per share or yield, these indexes make no distinction between large and small companies. A $100 million company with a 4 percent yield may get the same weighting as a $100 billion company with a 4 percent yield. This may lead to some investability constraints as investors try to buy significant stakes in smaller, higher-yielding companies.
- Due to ever-fluctuating yields and dividends, these strategies engender significant turnover and therefore higher transaction costs-a key concern for cost-conscious index investors.
A New Approach
To address some of these issues, Morningstar has developed a new set of dividend-based indexes: the Morningstar Dividend Composite Index and the Morningstar Dividend Leaders Index, with the Leaders Index consisting of the 100 highest-yielding stocks in the Composite Index. All stocks that meet the dividend consistency and sustainability rules form the Dividend Composite Index. Like other dividend indexes, both Morningstar indexes focus exclusively on dividend-paying stocks. (See Figure 1 for specific selection methodology.) However, a new weighting scheme aims to improve macro consistency, investability and turnover.[4]
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