Buy US Dividend Aristocrats ETF for resilience

"The superior earnings visibility and relatively stable revenue stream of a dividend aristocrat have contributed to the fund's resilience during periods of market weakness," says Mick Gilligan, head of research at Killik & Co.

SPDR S&P US Dividend Aristocrats has both capital growth and dividend income characteristics because it focuses on companies with a track record of growing their shares rather than just the highest yielders. "It's not just stocks with the highest dividends at the moment, which can be risky if those payout ratios are unsustainable," says Caroline Gutman, passive fund analyst at Morninstar. "Rather, it's stocks with lengthy records of dividend payments. Selecting stocks for dividend growth, as this fund does, serves as a quality screen. But because the fund requires two decades of consecutive growth, it could miss out on new high-quality dividend payers."

Companies with 20 years of consecutive dividend increases tend to have above-average dividend yields, relatively stable revenue streams and good earnings visibility. As a result, the US dividend aristocrat strategy has proved more resilient than the broader S&P 500 Index during periods of market weakness. "We saw this in 2000 to 2002, 2008 to 2009 and 2011, although not during the taper-related correction in early 2013," says Mr Gilligan. "2014 has proved a relatively benign period for the US stock market, although in all three of the 3 per cent-plus corrections of the S&P 500 so far this year, SPDR US Dividend Aristocrats has held up better. We attribute this to the more defensive earnings streams generated by aristocrat stocks."

But the shares are expensive with the dividend aristocrat portfolio on a price-earnings ratio of 19.2 times, according to Mr Gilligan. Its defensive profile also means the ETF is likely to underperform the S&P 500 in periods where low dividend yield sectors perform strongly and higher dividend yield sectors lag. For example, the S&P 500 returned 30 per cent in 2013 and 9.6 per cent to the end of August 2014, while over the same periods SPDR S&P US Dividend Aristocrats returned 27.1 per cent and 6.6 per cent respectively in net asset value terms.

Historically, value stocks have offered better risk-adjusted returns than their growth counterparts but can remain out of favour for years, and a concern issue for dividend-paying stocks at the moment is a potential increase in interest rates.

"Dividend-paying stocks tend to outperform in stable or declining rate environments but struggle when rates are on an upswing," says Ms Gutman. "If the economy is booming, stable dividend-paying stocks don't generate as much investor demand as riskier stocks from cyclical and speculative sectors. When rates rise because the economy is growing healthily, defensive sector stocks in particular become an expensive trade. SPDR US Dividend Aristocrat's 36 per cent allocation to defensive stocks is higher than the S&P 500's 26 per cent weighting."

"But we retain our buy rating given the low levels of leverage among portfolio constituents, higher than average returns on equity and resilience during periods of market weakness," adds Mr Gilligan.

US shares are expensive so there is an argument for using a low-cost ETF to access the market rather than pay considerably higher costs for active funds.

SPDR S&P US Dividend Aristocrats UCITS ETF has a total expense ratio (TER) of 0.35 per cent while active funds in that space typically have ongoing charges in excess of 1.6 per cent.

Active large-cap US funds also have difficulty in consistently outperforming the market.

SPDR US Dividend Aristocrats has tracked its index closely, delivering 61.43 per cent since inception three years ago against 61.12 per cent for its index. The slight outperformance is due to the fund's ability to reclaim US withholding tax. Mr Gilligan says he would like to see lower fees on this fund now it has grown to nearly $2bn. This week State Street has announced a cut in the fees of a number of its other ETFs.

RIVAL ETFS TO CONSIDER

SPDR US Dividend Aristocrats is the only London-listed ETF that tracks the S&P High Yield Index, and until this year was the only US equity income ETF. But two further funds have listed in London. In January db X-trackers MSCI North America High Dividend Yield Index UCITS ETF (XDND) came to market with an all-in fee of 0.39 per cent, and was followed in June by iShares MSCI USA Dividend IQ UCITS ETF (HDIQ) with a TER of 0.35 per cent. They are respectively £64m and £18m in size, and like SPDR S&P US Dividend Aristocrats they use physical replication - ie, they buy some or all of the shares in the index they track.

The db X-trackers fund tracks the MSCI North America High Dividend Yield Index, which is composed of large- and medium-sized US and Canadian companies with a dividend rate at least 30 per cent higher than its parent index, the MSCI North American, and have sustainable dividend returns. Dividends and distributions are reinvested in the shares after tax so the ETF does not pay out dividends. Compounding of reinvested dividends has proved to be a strong driver of returns historically, so this fund could be an option for longer-term growth investors rather than those seeking an immediate income.

iShares MSCI USA Dividend IQ UCITS ETF makes payouts twice a year. It tracks MSCI USA High Dividend Yield Index, which is composed of companies from the MSCI USA Index (excluding real estate investment trusts) which have higher than average dividend yields, track records of consistently paying dividends and the capacity to sustain dividends.

Source: Morningstar & *SPDR

Cumulative performance (%)

Source: SPDR, as at 31 August 2015

Top 10 holdings (as at 26 September 2014)

Sector breakdown