Investors flock to high-yielding European dividend funds

Want to add some income-generating stocks to your portfolio? Then look no further than Europe.

That's right. The region that's given investors numerous heart palpitations over the last few years has some of the juiciest dividends in the developed world.

As of April 7, the MSCI Europe has a 2.9 percent yield, according to FactSet, which is a lot better than the S&P 500's 2.05 percent payout. Many investors have already bought in, with $11 billion flowing into European dividend funds year-to-date, versus about $7 billion for all of 2014, said EPFR Global, a company that tracks global fund inflows and outflows.

A trader works at the stock exchange in Frankfurt, Germany, Feb. 17, 2015.
Thomas Lohnes | Getty Images
A trader works at the stock exchange in Frankfurt, Germany, Feb. 17, 2015.

The top three global European dividend mutual funds—CPR Euro High Dividend, Schroder ISF European Dividend Maximiser and Santander Dividendo Europa FI—have had collective net inflows of about $330 million so far this year, according to Morningstar. The SPDR S&P Euro Dividend Aristocrats ETF, the top-performing European dividend ETF, has net flows of nearly $200 million year-to-date.

There are two main reasons why European dividend funds are so popular today. The first is that people are feeling more comfortable with the region in general, and the second is that low interest rates around the world are causing people to look for higher-yielding products, said Jeremy Whitley, head of U.K. and European equities at Aberdeen Asset Management.

"There have been a lot of problems across Europe, so it's been a lot easier for international investors to look elsewhere for their returns," he said. "It seems now, though, that we have a more even playing field between European stocks and stocks around the world. People are having another look."

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That comfort has come, in part, because of the European Central Bank's 60-billion-euro-a-month quantitative easing program, which stared in March. QE often has a positive effect on stocks. As well, the euro's depreciation against the dollar—it's down 20 percent year-to-date—has helped buoy exports.

There's also less of a concern around some of its weaker countries, like Greece, said John Apruzzese, chief investment officer at New York-based investment firm Evercore Wealth Management.

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"Even if Greece gets kicked out of the euro zone, the general feeling is that it's not going to cause a major crisis for all of Europe the way it would have a few years ago," he said. "It's not a serious issue."

Europe's dividend culture

When it comes to dividends, Europe has long had a "dividend culture," said Dominic Wallington, chief investment officer with RBC Global Asset Management's U.K. operations. He's not sure why it started, but companies have been putting an emphasis on profit sharing with shareholders for years.

"We observe that distribution rates in Europe are higher than in most other regions," he said. "Other companies in other cultures are more concerned with either building up cash on the balance or growing the business."

"Many of these European companies have double-digit increases every year over 20- and 30-year periods," said Wallington. "That's not something that's ever talked about. If you reinvest those dividends, the compounding you can get is phenomenal."

For European-based businesses, dividends are a good thing because it imposes capital discipline, said Wallington. Most aren't spending recklessly—that dividend payment keeps them honest.

"If you distribute 60 percent of your earnings, then you have to be very careful with the rest," he said. "That kind of discipline isn't something you see as much in other cultures."

Sector payouts

While investors can get market yields with ETFs or better-than-market yields by owning certain funds, for stock pickers, not all sectors are created equal.

A number of industries have been driven up in value by investors, both income-seeking and not. Pharmaceuticals, for instance, is one area that Jörg de Vries-Hippen, chief investment officer of European equities with Allianz Global Investors, is staying away from.

The health-care space in general yields about 2.4 percent, which isn't good enough for him. As well, many companies are expensive. It's a similar story for consumer staples stocks, which are yielding, on average, 2.7 percent.

"Some of these are good companies, but the dividend they pay on these valuations are too low," he said.

He does like European reinsurance companies, like Munich Re, which is in his top 10 holdings, because they tend to have high and stable cash flows and clear business models. Their growth opportunities are limited, too, so they'd rather pay out profits than hang on to cash for no reason.

There are also good opportunities in European oil companies, he said. Many are cheaper than they have been because of the oil price drop, and they've also been forced to fine-tune their balance sheets. While this sector could be bumpy in the short term, when oil rebounds, these operations will be in a better payout position.

Royal Dutch Shell, which purchased BG Group for $70 billion on April 8 and has been paying a dividend since the end of World War II, is also one of the top holdings in Vries-Hippen's Allianz European Equity Dividend fund.

Don't get greedy

In this more attractive dividend locale, it can be easy for income-seekers to get carried away, but Aberdeen's Whitley said to watch out for companies that pay yields above 5 percent or so.

Just because the region has a culture of dividend payments doesn't mean these companies won't slash their payouts if they have to.

Just like with any dividend-paying operation, you want to make sure that payout ratios are sustainable—Vries-Hippen likes to see pay ratios of around 50 percent—that the company is growing its cash flows in order to at least maintain that dividend, and ideally, it's a plus if that payment per share is growing every year.

Whitley wants his companies to pay, on average, about 4 percent. Some can pay less, but then that dividend should be growing. Others can pay more, but then he'll have to make sure that the payout isn't at risk for cut.

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There is some worry that the influx of dollars into the market will depress dividends—high stock prices push yields lower—and they have gone down about a percentage point since the start of the year.

Vries-Hippen, though, thinks while we could see a lower overall yield in the short term, a better economic climate in the region will increase company profits in the long term and ultimately allow companies to increase their dividends.

"If QE really works in the direction we believe, the profits and cash flow development will be positive," he said. "Then these companies will be able to pay even higher dividends."

European stock dividends

Index/Sector Trailing 12-Month
MSCI Europe 2.90%
MSCI Europe / Consumer Discretionary -SEC 2.10%
MSCI Europe / Consumer Staples -SEC 2.70%
MSCI Europe / Energy -SEC 4.50%
MSCI Europe / Financials -SEC 3.40%
MSCI Europe / Health Care -SEC 2.40%
MSCI Europe / Industrials -SEC 2.40%
MSCI Europe / Information Technology -SEC 1.60%
MSCI Europe / Materials -SEC 2.90%
MSCI Europe / Telecommunication Services -SEC 3.60%
MSCI Europe / Utilities -SEC 4.70%
Source: MSCI