Capturing dividend growth stocks while maintaining representation and diversification
Interest among market participants is growing in “dividend growth” companies – those that pay increasing dividends over time. The Russell Dividend Growth Index Series is designed as a tool for use by market participants in this area, and the indexes are designed to avoid concentrated individual constituent or sector exposures. We examine the construction methodology, along with performance and characteristics of the indexes.
- Interest among market participants is growing in “dividend growth” companies – those that pay increasing dividends over time.
- The Russell Dividend Growth Index Series is designed as a tool for use by market participants in this area, and the indexes are designed to avoid concentrated individual constituent or sector exposures.
- Over more than 19 years, the three Russell Dividend Growth Indexes achieved an annualized return ~ 2-4 % higher than their respective parent indexes, with significantly improved Sharpe ratios.
Based on an analysis of Russell U.S. index constituent data from 1987-2014, companies that regularly increased their dividend payments over a period of ten years or more returned a year-on-year average of 13.9%, as opposed to the year-on-year average 10.1% returns of companies that paid dividends but did not increase them.1 This paper introduces the Russell Dividend Growth Index Series, which includes U.S. stocks that have succeeded in increasing their dividend payments over a period of ten years or more.2 Companies are screened for liquidity and dividend payment status, then selected and equal-weighted on a quarterly basis, subject to a maximum sector weight of 30%. These indexes, constructed using FTSE Russell’s transparent, rules-based methodology, are ideal tools for research, for benchmarking exposure to this interesting market segment, and for creating tradable products such as ETFs. An outline of the construction methodology is presented, along with structural and performance characteristics of the indexes.
Why invest in dividend-growing companies?
A common strategy among investors is to invest in “growth” companies – those whose key objectives include increasing their turnover, often by reinvesting profits into their businesses in order to fund business growth, in lieu of paying regular dividends. Their shareholders believe that over the long term this will lead to greater share price outperformance over that of the broad market. However, many other investors believe that conversely, the practice of paying dividends – among companies generally considered to be “value” companies – indicates a greater commitment to returning cash to shareholders, and through a combination of share performance and dividend payments, a better overall performance. The belief is commonly known as the “Dogs of the Dow” investment-selection approach, which was popularized by O’Higgins and Downes in 1991.3
A smaller group of companies issuing stocks, however, pays increasing dividends over time. These companies are viewed by some investors as demonstrating particular management confidence in future earnings; balance sheet strength and strong market performance; and commitment to creating shareholder value. Increasing dividends may be seen as an indicator of these companies’ long-term potential for better performance in terms of higher returns, lower volatility and/or smaller drawdown risk.
The Russell Dividend Growth Index Series
To meet the needs of investors who seek to focus on companies that are growing their dividends, FTSE Russell has created the Russell Dividend Growth Index Series, a series of indexes that tracks the performance of U.S. companies that have consistently increased their dividend payments over ten or more years.4 Each Dividend Growth Index is a specially selected subset of a parent Russell U.S. market cap-weighted index, as identified in Table 1.
Table 1: Russell Dividend Growth Indexes and their respective parent indexes
The initial starting universe for each Russell Dividend Growth Index is the parent index noted in the above table (Table 1). Screens are then applied to ensure replicability (liquidity and tradability screens), dividend growth and diversification.
Liquidity and tradability screening
For each of the three Dividend Growth Indexes, the same liquidity and tradability screen is used. This is created using the Russell 2000 index constituents, which are ranked in order of 20-day average daily dollar traded volume (ADDTV)5. The ADDTV of the company at the 20th percentile is noted, and this ADDTV threshold, computed from the Russell 2000 constituents, is applied to the constituents within each of the three parent indexes. For each universe, therefore, constituents that are at or above that threshold comprise the set of securities eligible for further screening.
Dividend growth criteria
The remaining securities are assessed for dividend growth over time. Eligible securities must have paid increasing per-share regular cash dividends for ten or more consecutive years. They must meet either of these two conditions:
- Increasing annual dividend per share (DPS) in each year, over ten years.6
- If dividend data is missing for any individual quarter, quarterly DPS must have increased at least once in each of the last ten years, and there must not have been any decreases in quarterly DPS.
Diversification: Constituent selection and weighting process
- FTSE Russell then assesses the number of remaining eligible stocks in each universe. Where there are fewer than 40, constituents with nine years of increasing dividends are added to the remaining list in descending order of dividend yield, until the total number of remaining constituents is 40. If there are still fewer than 40, constituents with eight years of increasing dividends are added. If after this step there are still fewer than 40 constituents, no further additions are made.
- The remaining stocks are equal-weighted.
- Where any sector represents 30% or more of the index, constituents are removed from that sector in ascending order of dividend yield until the sector represents less than 30%.
- If the total number of remaining constituents is fewer than 40, constituents with nine years of increasing dividends are added to sectors with weights below 30%, in descending order of dividend yield, until there are 40 constituents. If there are still fewer than 40, the process is repeated, using constituents with eight years of increasing dividends. If after this step there still are fewer than 40 constituents, the process is not continued further.
Reconstitution and quarterly review
To maintain its relevance and representativeness over time, each index in the Russell Dividend Growth Index Series is completely reconstituted annually in June, in parallel with the reconstitution of the Russell indexes.7 To reduce the deviation from constituent equal weights resulting from market movements, the indexes are rebalanced to equal weight each quarter, at the close of the last business day in both March and September. In December, the rebalance is completed at the close of the third Friday of the month.
Russell Dividend Growth Index Series – characteristics
How different are the Russell Dividend Growth Indexes when compared to their parent indexes? In the following section, we report major differences in key company characteristics between the Dividend Growth Indexes and their respective parent indexes, as well as differences in sector and style exposures.
Key descriptive statistics
Table 2 presents general statistics showing the effect, as of December 31, 2015, of applying the Russell Dividend Growth Index Series methodology. For both the Russell 1000 and Russell 3000 Dividend Growth Indexes, the dollarweighted average and median market capitalization fell, showing a tilt away from the largest constituents of the parent indexes. For the Russell 2000 Dividend Growth Index, on the other hand, the dollar weighted average and median market capitalization was similar to that of the parent index despite the significant drop in the number of constituents from 1988 to 56.
Five-year average dividend yield in the broad-market Russell 3000 and large cap–focused Russell 1000 both increased notably, from 2.0% to 2.8% and 2.7%, respectively. In the small cap part of the market, the increase in the 5-year average dividend yield of the Russell 2000 Dividend Growth Index relative to the parent Russell 2000 Index was even greater – from 1.5% to 2.9%. Additionally, the 5-year average dividend payout ratio was significantly higher for the Dividend Growth Indexes compared to the broader parent indexes, more than double in the case of the Russell 2000 Dividend Growth Index.
Average price-to-earnings declined slightly for the Russell 1000 Dividend Growth Index and the Russell 3000 Dividend Growth Index, and declined by over a third in the Russell 2000 Dividend Growth Index compared to the Russell 2000. Typically growth-oriented measures such as 1 Year EPS forecast – I/B/E/S and 5-year EPS growth were lower for the Dividend Growth indexes compared to the parent indexes. This is consistent with a tilt toward value examined later in this paper. However, 10-year earnings variability was significantly lower for the Dividend Growth indexes compared to the parent indexes.
Table 2: Index characteristics as of December 31, 2015
Source: FTSE Russell, data as of December 31, 2015. Please see the disclaimer page for important legal disclosures.
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1 Source: ProShares and Ned Davis Research: Russell 3000 constituent analysis, February 2, 1987, to December 31, 2014.
2 In certain rare circumstances, companies with fewer than ten years of dividend growth could be included in the indexes. These are explained in the section “Diversification: Constituent selection and weighting process” on page 4, as well as in the index construction and methodology document available from ftserussell.com.
3 O’Higgins, M., with J. Downes, 1991, in Beating the Dow, HarperCollins.
4 For more information, refer to the construction and methodology at ftserussell.com.
5 ADDTV is defined as the accumulated trading value over the past twenty trading days, divided by twenty. For additional information on ADDTV, refer to the Russell Global Index construction and methodology document available at ftserussell.com.
6 In certain rare circumstances, companies with fewer than ten years of dividend growth could be included in the indexes. These are explained in the section “Diversification: Constituent selection and weighting process” on page 4, as well as in the index construction and methodology document available from ftserussell.com.
7 Reconstitution of the Russell Global Index and the Russell Dividend Growth Index Series is effective the last Friday in June, with the following exceptions: If the last Friday in June is the 29th or 30th, reconstitution will occur on the Friday prior. A full calendar for reconstitution is made available each spring on ftserussell.com. More information on the reconstitution of the Russell Global Index is included within the Russell Global Indexes Construction and Methodology document, available at ftserussell.com.