QDF - QDF: The Dividend ETF With Excellent Quality But Vulnerabilities Elsewhere

2023-05-11 14:56:43 ET

Summary

• QDF leverages a passive strategy with a portfolio of top-quality U.S. dividend-paying companies.
• What I find unappealing is its last twelve months' dividend yield of just ~2.3%, sluggish growth in distributions (the negative 3-year compound annual growth rate), and past performance overall.
• Regarding factor exposure, I again hardly see a meaningful reason to rate it a Buy, although there are a few advantages worth discussing.

FlexShares Quality Dividend Index Fund ( QDF ) leverages a passive strategy with a portfolio of top-quality U.S. dividend-paying companies. The quarterly rebalanced Northern Trust Quality Dividend Index, which is the cornerstone of its strategy, has a multi-step nuanced methodology, with a few complex screens designed to boost quality exposure, bolster the dividend yield, and achieve a beta which should be in line with the one of the Northern Trust 1250 Index, which serves as a parent index.

According to the prospectus , the security selection process starts with the above-mentioned index as a selection universe. Constituents that do not pay a dividend together with those " that rank in the lowest quintile of quality based on a proprietary scoring model" are filtered out on step one. The three components of the model are management efficiency, profitability, and cash flow generation. The next step is the optimization process when the index provider selects securities and assigns weights to them pursuing higher overall quality, while bolstering the dividend yield that should be in excess of the one of the parent index, also with a goal to " achieve the desired beta target." I recommend reading the prospectus and index methodology document for a better understanding of the constraints applied and the construction process overall.

Even though the methodology might look promising, I am of the opinion there are not enough directly or implicitly bullish factors to assign a Buy rating to QDF. What I find unappealing is its last twelve months dividend yield of just ~2.3%, sluggish growth in distributions (the negative 3-year compound annual growth rate), and past performance overall; the context used are the results delivered by the pool of the 60 dividend ETFs I have covered on Seeking Alpha to date. Regarding factor exposure, I again hardly see a meaningful reason to rate it a Buy, although there are a few advantages worth discussing.

Delving deeper into the portfolio, addressing factor exposure

With 135 names (excluding cash and derivatives) in its portfolio as of May 8, QDF favors the information technology (27.3%), healthcare (15.1%), and financial (13.6%) sectors, in line with the Russell 1000 index, which the ETF uses for performance comparison purposes in its fact sheet, and also obviously in line with the fund that tracks it ( IWB ).

What I find fairly surprising is Apple ( AAPL ) having an approximate 9.5% weighting in the QDF basket, with Microsoft ( MSFT ) also being a key holding with a 5.67% weight. I am of the opinion that such substantial allocations to the low-yield tech bellwethers (55 bps and 88 bps, respectively, as of May 10) that occupy the top spots in the iShares Core S&P 500 ( IVV ) and Invesco QQQ ETFs ( QQQ ) are clearly excessive; I believe a weight approaching 10% for Apple would be justified for a tech or tech-ish investment vehicle pursuing growth, innovation, or something akin, not for one mixing the dividend and quality factors and also attempting to achieve a modestly higher yield. With that being said, these names certainly also bolster the fund's quality factor exposure, which I will elaborate on in the ensuing paragraphs.

As a consequence of the trillion league titans being the principal holdings, and mega-caps overall having close to 56% weight, QDF's weighted-average market cap stood at around $526.8 billion as of May 10, as per my calculations. Small wonder the fund has allocated over 96% to companies with a B- Quant Profitability grade and higher as the large size factor correlates with industry-leading margins and returns on capital, but exceptions might emerge when valuations disconnect from reality during rampant bull markets. Even though there are a few mid-cap names, which by the way, account for most value plays in the portfolio, none has quality issues worrisome enough for a D+ rating or weaker. None of the companies (ex-financials) are EBITDA-negative, with the median margin standing at ~28.5%, as per my calculations. Most importantly, firms outspending net operating cash flows are absent, which indicates that all the players are not only capable of optimizing costs but also of excellently managing their working capital.

Besides, the median Return on Total Capital is about 13.6%, a strong indication of most holdings proficiently using shareholder and debt investor funds. Another metric that delivered a pleasing surprise is the Return on Equity/Return on Assets spread, with ROE of 48.5% and ROA of 13%. It is worth noting that AAPL and MSFT are among the key contributors to the latter, with their ROA at 28.4% and 18.2%, respectively.

Overall, the index provider did an excellent job removing impecunious, cash-burning companies and distilled a top-quality mix. But what price do investors pay for this level of quality? And is growth exposure adequate?

Unfortunately, QDF's equity mix is valued rather generously. Its weighted-average earnings yield is 6.8%, as per my calculations, which is much higher compared to 4.9% of IVV. However, with over 62% of the holdings having a D+ Quant Valuation grade and worse, QDF is hardly cheap. And the 5.4% forward EPS and 4.5% forward revenue growth rates, again, as of my calculations, are also supportive of a more skeptical tone.

Bleak yield, dividend growth leaves a lot to be desired, soft performance

Unfortunately, despite the fund currently having excellent quality, there are a few downsides that are not supportive of a Buy rating, principally its weak performance, low yield, and unappealing dividend growth.

Amongst the 60 dividend ETFs, I cover (including those focused on overseas equities, specific echelons of the U.S. market, adding quality or value ingredients, etc.), last twelve months' dividend yields vary from Federated Hermes U.S. Strategic Dividend ETF's ( FDV ) measly 79 bps to Global X SuperDividend ETF's ( SDIV ) gargantuan 14.3%, the median DY is at 3.3%. Here, QDF scores rather poorly, offering around 2.3%, with a 4-year average at 2.76%; for better context, IVV, which is a nice approximation of the U.S. market, comes with 1.58%.

Regarding growth, the median 3-year dividend CAGR in this pool is 4.65%, factoring in two ETFs that do not have a 3-year distribution history since they were launched in 2022, namely FDV and Capital Group Dividend Value ETF ( CGDV ). Here, QDF looks even weaker, with a negative CAGR of 6.8% .

Speaking of performance, the median 5-year total return in the group of 51 dividend funds (nine do not have the 5-year data) is ~14.6%, while QDF delivered almost 21%. However, the 3-year total return is less attractive; the pool's median is 47.7%, while QDF achieved only 43.5%. The one-year price return is also slightly below the median (negative 97 bps as of May 10 vs. negative 2 bps).

Besides, during the January 2013 - April 2023 period (QDF was incepted in December 2012), the fund delivered a much softer annualized return compared to IVV and iShares Russell 1000 ETF, underperforming by ~2.1% and ~1.8%, respectively. One of the major culprits here is its inability to benefit from the 2020 pandemic rally when it delivered a total return of just 4.9% vs. IVV's 18.4% and IWB's 20.8%.

Created by the author using data from Portfolio Visualizer

Final thoughts

QDF is a passively managed ETF mixing quality and dividend factors in a portfolio of U.S. companies, while also optimizing beta. Though with a promising strategy, the fund has weak past performance and its dividend characteristics are hardly spectacular. In sum, QDF is neither a top choice for investors on the hunt for a high-quality strong-yield fund, nor a vehicle to consider for those seeking to capitalize on the growth style recovery.

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