In 1991, money manager Michael B. O’Higgins published a book called Beating the Dow. It popularized a simple strategy for dividend investors known as the “Dogs of the Dow” buy the 10 stocks with the highest yield in the 30-member Dow Jones Industrial Average, then update the portfolio by buying the top 10 payers – and selling ones that fell off the list – every year after that. The strategy worked 30 years ago, outperforming the Dow itself.

Today, the demand for income-producing investments is a lot greater than it was 30 years ago. As our society has aged, retirees in need of regular cash flow now make up a far greater share of the population. Meanwhile, the collapse of bond yields – rates on the 10-year U.S. Treasury have fallen by 62% since the Great Recession – has made income-producing investments harder for them to find. Not surprisingly, dividend equity funds and exchange-traded funds (ETFs) have proliferated. Sadly, the strategies used by most of these funds have advanced little since the Dog days.

Most equity income ETFs fall into two categories. The first group seeks out the highest dividend payers in their investing universe, like the Dogs of the Dow. The second is only slightly more sophisticated, targeting so-called dividend “aristocrats” that have a history of increasing their dividends every year.

The problem with the high-yield strategy is that you end up owning companies at risk of cutting their dividends and destroying shareholder value. Say a stock starts the year at $100 a share with a 3% dividend yield. A high-yield fund likely wouldn’t consider it. But if that stock falls to $50 and the yield rises to 6%, suddenly it’s eligible for inclusion in the portfolio. But is it a good buy? Maybe not.

“There are high-yielding ETFs out there that give you higher than average yield, but the price return is negative,” says Trevor Cummings, vice-president of ETF Distributions at TD Asset Management Inc. (TDAM), adding that when stock prices fall, yields rise. “Why would anybody be happy with that?”

The aristocrats strategy at least acknowledges that not all dividends are created equal. It prizes not only dividend sustainability but also dividend growth. The problem is that it’s backward-looking. It includes stocks that have increased their dividends over the past five or 10 years without considering their capacity to keep boosting their dividends in the future.

“That’s the end of the thought process,” Cummings says. And, as in investing, past performance is not always the best predictor of future returns.

Screening for solid companies

Because of the lack of more forward-thinking dividend strategies on the market, TDAM developed two ETFs – TD Q Canadian Dividend ETF (TQCD) and TD Q Global Dividend ETF (TQGD) – designed to grow investors’ income over the next 10, 15 or 20 years.

Both ETFs employ quantitative strategies. They use a series of screens to filter out dividend stocks with characteristics that often lead to a dividend slash, such as high leverage, negative earnings, and low or negative current ratio and liquidity ratio. Those that make the cut are then scored on their desirable attributes, including return on invested capital, profit trend and dividend growth trend over the past few years. The highest-scoring stocks get included in the portfolio.

“The most important aspect is not the dividend yield, it’s the stream of dividends – you want to be sure it’s sustainable and growing,” says Julien Palardy, managing director, TDAM in charge of the quant team that oversees TQCD. “It’s also about the compounding as dividends get reinvested.”

Just because TDAM uses a quantitative strategy does not mean it’s passive. If the model says to trade a company when it cuts its dividend, TDAM’s team will check first to determine whether the cut is likely to be permanent before selling, for example. Moreover, the model is constantly subject to testing and monitoring to ensure it’s indeed doing what it’s intended to do.

“Quant is still active. It’s just a different kind of active,” Palardy explains. It strives to eliminate the biases that can lead stock-pickers astray. “The quant approach gives us a lot of objectivity in how to assess the data that’s available to us.”

Buying great businesses

Not every investor is philosophically comfortable with an algorithm-driven strategy, of course. For those people, TDAM also offers actively managed ETFs with features designed to maximize total return. The TD Active U.S. Enhanced Dividend ETF (TUED) and TD Active Global Enhanced Dividend ETF (TGED), for instance, combine dividend stocks with attractive fundamentals and more growth-oriented stocks that can still provide a robust total return. They use an options overlay strategy with the goal of enhancing the income and do this actively using a couple of different methods.  The first is writing covered calls to help enhance income on current holdings. These funds can hold a percentage of non-dividend companies, and with the use of call options can turn these non-dividend payers into synthetic payers.  Secondly, they write puts using the excess cash on companies they'd like to own at lower prices.

If all a dividend fund will consider is stocks yielding 3% or more, “you’re going to miss out on a lot of great businesses,” Cummings explains. Instead, TUED and TGED include companies such as ASML, Amazon, Alphabet and Estée Lauder, holdings as of September 26, 2021, with the thinking that it’s better to own strong businesses, and generate an income stream from them, than to confine your choices to just high-dividend payers.

As the markets move ever faster and assimilate larger and larger volumes of data, “you can’t just take a rule set off the shelf from 20 or 30 years ago and assume it’s going to work into the future,” Cummings says. “You have to do more. It’s only going to get harder.”