By: Tom Goodwin, Senior Research Director
When shopping for a car, the value-minded consumer seeks quality and long-term durability at a reasonable price. This mindset can also be applied to indexing. For many market participants, evaluating stocks by price alone is not enough—they want quality characteristics, too. This can be especially pertinent when evaluating a small cap universe, like the constituents of the Russell 2000 Index, in this current period of heightened uncertainty. By filtering this universe for certain characteristics of quality, our value-minded consumer might evaluate stocks using the same traits they seek in their new car.
The Russell 2000 Dividend Growth Index (“Dividend Growth Index”) is screened to include only those stocks from the Russell 2000 that have increased their dividend payment over each of the last ten years. By distributing an increasing amount of income to shareholders, these companies have demonstrated management confidence and a commitment to creating shareholder value. A look under the hood of the Dividend Growth Index will show whether the filters applied satisfy the needs of our consumer.
In the table and chart below, we can see that the Dividend Growth Index has demonstrated a higher return and lower volatility than its reference index over the last 16 years. One driver of this could be the higher dividend yield inherent in the Dividend Growth Index — 2.46% compared to 1.55% for the Russell 2000. But this only gives us part of the answer.
As we will see it is not just the higher dividend payments that are behind this higher performance. In a previous post, we highlighted how sector weighting and especially security selection drove much of the higher performance of the dividend growth indexes compared to the relevant reference indexes. Here we will evaluate this performance through the lens of a factor analysis.
We start with the well-known factor model of Fama and French. Starting with the three standard factors of market beta, small cap and value exposures, we then add quality exposure as the fourth factor due to recent research.
The following table shows the results of running a regression of the return of the Dividend Growth Index over a cash return on the four factors. We will briefly describe each in turn.
Market beta measures how sensitive the Dividend Growth Index is to market volatility. A coefficient of one or greater would mean that the index is very sensitive to market volatility. Here, we see that the market beta is well below one, indicating that the index has reduced sensitivity to market volatility.
Small cap is the return to a long-short index universe of stocks that is long in small cap stocks and short in large cap stocks. The coefficient measures the index’s exposure to small cap and it is no surprise that it is statistically significant for the Dividend Growth Index, which is based on a small-cap universe.
Value is the return to a long-short index universe that is long in high book-to-price stocks and short in low book-to-price stocks. The coefficient measures the index’s exposure to these less expensive stocks. Interestingly, the estimated exposure is even larger than the estimated small cap exposure.
Quality is return to a long-short index universe that is long in stocks with quality attributes like strong profitability growth, high return on equity and low volatility, among other things. The index universe is short those stocks with the opposite characteristics. We can see that the estimated exposure of the index to high quality is large and statistically significant.
If we take a look at a return attribution for each of the four factors, we can see how they impact the total return of the Dividend Growth Index. It should be no surprise that the largest contributor was the Market Beta to the broad market. What might be unexpected is that the return contribution of the Quality factor was almost as large as the contribution of the Small Cap factor. The Value factor also made a positive, but smaller, contribution.
The factor analysis shows that, by selecting companies that have successfully increased their dividend payments over many years, the Russell 2000 Dividend Growth Index occupies a corner of the small-cap space that is high in the quality and value factors. Those two factors combined with the Small Cap factor makes for three strong drivers of performance.
So a close look under the hood shows that the filters used to construct the Russell 2000 Dividend Growth Index can give our value-minded consumer the analysis they want—quality and value—just like their new car.
To read more on how indexes can be used to evaluate different segments of the market, see the FTSE Russell Blog post on dividend growth stocks.
 Data as of October 31, 2016.
 Fama, E. and K. French, “The Cross-Section of Expected Stock Returns,” Journal of Finance, 1992; Fama, E. and K. French, “Common Risk Factors in the Returns on Stocks and Bonds,” Journal of Financial Economics, 1993.
 Asness, C., Frazzini, A., and Pedersen, L. (2014), “Quality minus Junk,” Working paper AQR CapitalManagement, LLC.
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