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Advisors should examine closely how dividend aristocrats ETFs are constructed as they differ depending on the product manufacturer, an expert says.Michael M Santiago/Getty Images/Getty Images

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With more companies releasing dividend aristocrats exchange-traded funds (ETFs), some income-focused investors may be wondering whether these products are a suitable strategy in portfolios amid high inflation and interest rates.

Membership in the S&P 500 Dividend Aristocrats index has two requirements – a company must be in the S&P 500 and must have paid and increased dividends annually for a minimum of the past 25 years, says Simeon Hyman, global investment strategist at ProShares Advisors LLC in Bethesda, Md., whose offerings include ProShares S&P 500 Dividend Aristocrats ETF NOBL-A.

“It’s a simple rule with elegant results,” he notes. “For a company to be able to achieve that, it’s going to do a bunch of other things. It needs a solid balance sheet, market power and must manage capital well and grow real cash flow and earnings over and over again.”

Mr. Hyman sees the banking crisis, high inflation, shrinking margins and earnings as “bumps along the way,” creating a challenging market backdrop. But he also says that since the inception of the ETF in 2013, its dividends have grown around 11 per cent compounded year-over-year. There are currently no banks in ProShares S&P 500 Dividend Aristocrats ETF.

“Quality elements like the pricing power and margin expansion that [the ETF] has delivered of late gives you a lot of protection in a challenging market,” Mr. Hyman says. “But the growth of the dividend is the quintessential inflation hedge over the long term.”

In Canada, dividend aristocrats ETFs are managed a bit differently. Generally, qualified companies are listed on the Toronto Stock Exchange, have increased their annual dividend for the last five years, and have a market capitalization of a minimum of $300-million.

Invesco Canada recently launched five dividend aristocrats ETFs which add environment, social and governance (ESG) criteria to the mix. The strategies for Invesco S&P/TSX Canadian Dividend Aristocrat ESG Index ETF ICAE-T, Invesco S&P US Dividend Aristocrats ESG Index ETF IUAE-T (includes a series of Canadian dollar hedged units) and Invesco S&P International Developed Dividend Aristocrats ESG Index ETF IIAE-T (also includes a series of Canadian dollar hedged units), vary as they invest in different weighted indexes.

While Matthew Evans, chief investment officer and portfolio manager at Westmount Wealth Management Inc. in Vancouver, considers dividend aristocrats a style of investing that has some merits, he doesn’t hang his hat on a single investment factor.

“Styles can and do fall out of favour for a variety of reasons, and sometimes for long periods of time,” he says. “You don’t want to be in a position in which your factor tilt is underperforming the broad market for years.”

He cautions advisors to examine closely how dividend aristocrats ETFs are constructed as they differ depending on the product manufacturer. He says advisors should consider the limitations on individual securities and sector weights to understand whether the selection criteria complements or detracts from their investment objective.

“Depending on the constraints of the ETF, you could end up being overweight a sector like financial services, for example, which could magnify sector and interest sensitivity risk,” Mr. Evans notes.

How interest rates have an impact

Richard Croft, president, chief investment officer and portfolio manager at Croft Financial Group in Toronto, sees dividend aristocrats popular with seniors who are looking for income and an increase in cash flow over time.

“They are being marketed as a cash flow instrument in an inflation environment,” he says. “You’re buying a diversified portfolio of securities that have been increasing their dividends as interest rates rise.”

But increased interest rates are one downside to this investment strategy. Mr. Croft says when that occurs, it increases the overall cost of the companies invested in the dividend aristocrat index.

“Smaller companies [in the index] are continuing to increase their dividends and that’s going to be a very big challenge for the ETF’s bottom line,” Mr. Croft says. “That’s because some companies don’t have the earnings to support more dividends ... It’s just not sustainable.”

If companies choose not to raise dividends, they get pushed out of the index for not following the strict criteria of being a dividend aristocrat.

One alternative to these ETFs is buying individual stocks.

“Pick up the individual quality companies that are delivering the same metrics based on the objective of a rising income that is sustainable over the long term,” Mr. Croft says.

Scott Sather, president and certified financial planner at Awaken Wealth Management Ltd. in Regina, wonders about the effect of adding an ESG filter to the expected annual increased dividends.

“It’s going to reduce the number of companies that are actually available to investors,” he says. “They may get a higher rate of return by investing in smaller companies versus growth.”

He also notes there’s no premium investors receive for investing in companies that pay a dividend.

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Follow Deanne Gage on Twitter: @deannegageOpens in a new window

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