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Foreign Stock Dividends Promise Yields--and Trade-Offs

Investors should be sure to understand the issues with foreign dividend payers.

Foreign Stock Dividends Promise Yields--and Trade-Offs
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Christine Benz: Hi, I'm Christine Benz for Morningstar. Foreign stock dividends look tantalizing, but investors should be sure to understand the trade-offs of foreign dividend payers before investing. Joining me to discuss that topic is Dan Sotiroff. He's an analyst in Morningstar's Manager Research Group.

Dan, thank you so much for being here.

Daniel Sotiroff: Hey, Christine.

Benz: Dan, let's talk about foreign stock dividends. When I look at, say, a total international index versus a total U.S. index, I'm seeing a yield of like 3% on the foreign stock index versus maybe less than 2% on the U.S. index. So, what tends to cause those higher yields in foreign markets?

Sotiroff: Right. So, you got it about right. It's about a 1% spread, it has been for a little while. So, it is higher overseas. But really, it's kind of just a basic market composition sort of factor here. If you look at the U.S. and what's happened over the past decade, tech stocks have really dominated the U.S. market, right? So, the Googles, Microsofts, et cetera. Those are growth stocks that tend to pay out lower yields than other sectors of the economy. When you go overseas, the sector composition is just different. So, you have a lot more financials. Financial firms overseas make up all--you know, about 25% of foreign market indexes--and they're higher-yielding right now, too. So, it's really just that sector composition play that's really going on there.

Benz: So, that kind of leads to my next question about the risk factors that investors should bear in mind. You like that higher yield, especially if you're retired. What are some things you should bear in mind? It sounds like right out of the box you're getting different sector composition, and maybe some slower-growing industries.

Sotiroff: Right. So, there's some very basic stuff here, right? First, you're investing overseas. So, you've got the foreign-currency risk thing. Second is, you're buying companies that tend to trade at lower multiples. So, they probably have something going on. They're maybe not the most-valued companies in the world. They may not have the best prospects going forward. They are kind of value strategies at the end of the day.

So, that's going to actually drive their yields a little bit higher, right, lower prices. The third thing is, since these are value strategies, you tend to see some sector composition. And then that's one of the other trade-offs. You may be exposed to a little bit more sector-specific risk with some of these funds if you're not careful. So, those are really the real big risks that I would be watching out for with these types of strategies.

Benz: And the currency risk seems especially important for people who are in drawdown mode, people who are retired and spending from their portfolios. You're spending from that portfolio in dollars.

Sotiroff: Yeah. And as anybody knows, over the past couple years we've had an appreciating dollar. So, it's only made repatriating your money back to the U.S. that much more expensive. That exchange rate, you can't forget that when you're investing overseas.

Benz: So, if I'm looking at some sort of foreign dividend, or I want to incorporate a foreign dividend strategy into my portfolio, if I'm looking at a total international index, with a 3% yield, that's not a bad way to obtain that exposure.

Sotiroff: Yeah, it's actually not a bad way to get it. I mean, you get a really well diversified portfolio, so long as you're getting a cheap one that's well managed. Funds from Vanguard, Schwab, iShares, BlackRock, they're all great, and they all will fulfill that role. The other thing you could do is like, maybe if you've got like a U.S. and a total international fund, maybe just change your allocation slightly and move a little bit more over to the international side. But completely reasonable ways to go about getting some higher yield.

Benz: And that's going to be about as cheap as you'll be able to do.

Sotiroff: Yeah, exactly. Right. Yeah.

Benz: So, assuming I want to have some dividend-specific strategy that's in the foreign stock realm... You recently wrote a white paper where you looked at dividend strategies broadly, the pros and cons, and you also identified some funds that you and the team really like in this space. Let's look at one that focuses specifically on that higher-yielding universe, that is, Vanguard International High Dividend Yield. This one is available either as an ETF or a traditional index fund. Let's talk about why you like it.

Sotiroff: Well, like you mentioned, it takes advantage of Vanguard's dual share class nature. So, you get like the tax efficiency, whether you're in the mutual fund or the ETF. The other thing we like about it is it's a very well-diversified portfolio. So, what they do is they sweep in 50% of the market capitalization of the selection universe. So, you get this very broad portfolio, hundreds of stocks, that eliminates a lot of the company-specific risks we were kind of alluding to earlier. So, those are two things we like. They also weight by market capitalization. So, that really does two things in the dividend-yield space.

You're going to emphasize larger companies that are probably a little more stable, more likely to continue their dividend payment. So, those are all good things. The other thing it does is it reduces turnover. And that gets back to this cost-of-ownership thing, lower turnover, fewer trades that the portfolio managers have to make, which ultimately saves you money at the end of the day as the end investor in those funds. So, yeah, we think Vanguard International High Dividend Yield ETF is a great way to get exposure to the high-yielding foreign markets overall.

Benz: And Vanguard also fields an international dividend growth fund. Let's talk about that strategy. Its yield wouldn't tend to be as high as that high-yielding fund.

Sotiroff: So, it's really kind of at the opposite end of the spectrum is the way I would look at it. So, what you're doing is instead of--you're forgoing some yield to get dividend growth. So, that's the trade-off you're making here. You're going to have growthier funds in the portfolio. It tends to be--the companies that that portfolio holds tend to be a little more profitable, they tend to have wider moats. These tend to be more-stable businesses overall. So, it's a very different sort of dividends strategy. But it's another good way to play foreign markets. We're big fans of that fund as well.

Benz: Dan, always great to get your perspective. Thank you so much for being here.

Sotiroff: Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.

Daniel Sotiroff does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.