Morningstar Magazine - June/July 2017 - 84

Strategies

Dual Focus: Profits and Dividends
This ETF balances its yield mandate
with profitability to reduce risk.

BEST IDEAS: PASSIVE

Adam McCullough

This article is adapted from the ETF's Morningstar
Global Fund Report dated April 24, 2017.
FlexShares Quality Dividend QDF offers
a diversified portfolio of highly profitable stocks
with attractive dividend yields. This dual
focus reduces the fund's exposure to firms with
weak fundamentals that may not be able to
sustain their dividend payments, which is a risk
that often accompanies a narrow focus
on yield. The fund's low fee should contribute
to its edge over the long run, but its short
live track record and nontransparent process limit
its Morningstar Analyst Rating to Bronze.
The fund starts with the largest 1,250 U.S. stocks
by market capitalization. Next, it ranks these stocks
using a proprietary scoring model that combines
profitability, cash flow, and management efficiency
metrics. By targeting more-profitable dividendpaying stocks, this fund avoids some of the risks
associated with chasing yield. It also restricts
individual stock, industry, and sector weighting
deviations from its parent index, which should
reduce unintended bets. Despite its profitability
criteria, the fund still leans toward the value end of
the style spectrum and offers an attractive yield.
From its inception in December 2012 through
March 2017, this fund's yield averaged 3.9%, nearly
50% more than the Russell 1000 Value Index.
Because this fund's starting universe is larger
than peer dividend-seeking funds', its holdings
skew to the smaller side. Its weighted average
market capitalization is $40 billion, compared with
over $55 billion for the Morningstar Category

Morningstar June/July 2017

behavioral issues, giving investors fortitude to
weather volatility and alleviating the need to
realize capital gains to meet income requirements.

average. The fund's profitability tilt is evident. Its
return on equity has been nearly double the
category average since inception, and net margins
have been consistently higher.
This strategy launched in December 2012, so it has
not established a meaningful record through
a full market cycle. From inception through March,
the fund returned 15.7%, outpacing the largecap value category by 2.2% annually with similar
risk. Its underweighting to energy and favorable
stock selection in the consumer discretionary
sector contributed the most to its outperformance.
Fundamental View

In a theoretical frictionless market, dividendpayout policy shouldn't have any impact
on stock returns: A dividend payment should
reduce the stock price by an offsetting amount. In
practice, dividends often matter. They can impose
greater discipline on managers in their capitalallocation decisions, and managers may use these
payments to signal confidence in their firms'
prospects. Dividends can also help address

Chasing yield can be dangerous, though. The
highest-yielding stocks could be under financial
distress and more likely to cut their dividends than
their lower-yielding counterparts. Many of these
stocks pay out a large share of their earnings as
dividends, leaving a small buffer to cushion
these payments if their business deteriorates. This
fund strives to sidestep this risk by balancing
profitability and yield. If a stock is more profitable,
it should be able to maintain its dividend during a
downturn or raise its payout ratio in the future.
Although this fund's profitability tilt helps it avoid
the riskier, highest-yielding stocks, its yield has
consistently topped the category average by 30%.
This portfolio is different than traditional value
benchmarks like the Russell 1000 Value
Index. Most notably, it holds a higher percentage
of consumer discretionary and technology names
and has less exposure to energy and financial
services. Not surprisingly, the fund's holdings
were expected to pay out a larger share (60%)
of their earnings as dividends at the end of March
than the Russell 1000 Value Index (41%),
based on Morningstar calculations. They also
tend to generate higher average returns
on invested capital than those in the index. High
profitability, coupled with conservative
capital investment and low valuations, should
allow the fund's holdings to offer high free cash
flow returns on capital.

FlexShares Quality Dividend QDF
Growth of $10K 04/30/2017

Stats 04/30/2017

13.10
FlexShares Quality Dividend ETF

12.55

Morningstar US
Large Value TR

04/2014

04/2015

04/2016

14K
$
12
10
8

Morningstar Category

Large Value

Inception Date

12/14/2012

Morningstar Analyst Rating

Expense Ratio

0.37%

3-Yr. Total Annual Return

9.42%

3-Yr. Total Rtn Category Rank

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