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Why Advisors Should Search for Quality Dividends Rather Than Yield

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For decades, dividend income has been a crucial component of a stock investor’s total return. It often surpasses returns from capital appreciation in volatile markets as income-seeking investors have widened their search for yield in the face of historically low interest rates, and dividends have served as a useful tool.

However, investors often take a flawed approach to evaluating dividend investments by focusing on the longevity and growth of dividend payments over time. The problem is that these metrics may not be indicative of a sustainable yield.

In the United States, the increasing demand for dividend income has been driven in part by valuations for many traditional dividend payers that are far above their long-term averages. Outside the United States, there are a number of companies in both developed and emerging international markets with historically high dividend yields.

Blindly focusing on dividend yield in the international sector, however, can be dangerous. Often, a seemingly generous dividend yield may cloud an ensuing weak share price tied to negative news not yet revealed in the quarterly dividend.

Clouded Judgment Through the years, several strategies have been adopted to avoid overpaying for dividend-driven yield. First, longevity. If a company has paid a dividend for a long time, investors may trust it will continue to do so.

The alternative, focusing on dividend growth over time, views a reduction in the distribution as a red flag, signaling the dividend may either be pared back or not paid at all in the future. Both approaches are flawed because:

1. They react to a reduced dividend only after it happens, resulting in holding the dividend-paying security until the next rebalance, well after the market bakes the negative dividend news into the stock price.

2. They require a long history of dividend payouts (often a decade or two) to properly evaluate a company, which means newer dividend payers are excluded from consideration.

3. They tend to downplay recent changes in the macro environment that may drastically affect the company’s ability to maintain or grow its dividend.

Further, a singular focus on payout ratios, which is the proportion of earnings paid out as dividends to shareholders, may eliminate companies in mature industries that return most of their income to shareholders but are financially stable and well positioned to actually maintain the existing dividend rate.

How can investors judge an “endurable” dividend? A better approach focuses on the core financial health of the underlying dividend-paying company and makes it possible to evaluate the likelihood that it will increase (or need to decrease) its future dividends. With this approach, the reliance on publicly available financial data means new dividend payers can be evaluated similarly to stocks that have paid dividends for decades.

By using several lenses to evaluate the actual financial health of dividend-paying companies, the FlexShares Dividend Quality Score (DQS) is designed to see how well positioned for success they are, and how protected future dividends may be in the future.

The scoring process takes into account a number of key factors including a company’s management efficiency, profitability, and cash flow, to help identify the highest-quality companies. Then, to balance systemic risks, FlexShares’ DQS process puts several diversification controls into place for their ETFs — such as setting the maximum weight that can be placed on any specific region, sector, or single security.

There are three international dividend ETFs designed to employ the innovative scoring process of the DQS, including the International Quality Dividend Defensive Index Fund (IQDE) and the International Quality Dividend Index Fund (IQDF).*

In light of the recent yield-starved environment, the International Quality Dividend Dynamic Index Fund (IQDY) might be of most interest, as it takes the most aggressive approach of the three and is designed to maintain a beta generally greater than one to the underlying index, while also having in place the DQS’ risk-control measures.

Chris Huemmer is Senior Investment Strategist at FlexShares.

*Before investing, carefully consider the FlexShares investment objectives, risks, charges and expenses. This and other information is in the prospectus and a summary prospectus, copies of which may be obtained by visiting www.flexshares.com. Read the prospectus carefully before you invest. Foreside Fund Services, LLC, distributor.

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