Dividend ETFs: Going Behind the Curtain

Dividend ETFs: Going Behind the Curtain Market Commentary 2018 WITH INTEREST RATES AT GENERATIONAL LOWS, exchange-traded funds (ETFs) that focus on dividend-paying securities have become a more prominent element of the investing landscape. The largest dividend ETF by assets was just under $5 billion in total assets in 2011. Today there are four dividend ETFs each with over $15 billion in total assets. 1 Dividend ETF investors may find themselves in the position of Dorothy from The Wizard of Oz, however, with outcomes dependent on forces hidden behind a curtain. We believe there is a widespread lack of clarity regarding the mechanics of dividend ETFs. We therefore think it may be helpful to pull back the curtain and disclose the inner workings of these ETFs in order to help investors make more fully informed decisions. Limitations of a Proprietary Selection Process Dividend ETFs normally begin their portfolio construction process with reference to a particular index that tracks dividend-paying securities. Committees determine the constituents of these indices at meetings that may be held quarterly, or even just annually. The specific process by which these committees determine security selections is almost never disclosed, as it is considered proprietary information; investors are requested to pay no attention to that committee behind the curtain! Nonetheless, within the limited range of available details, certain broad approaches are common. A given dividend-focused index committee may start with a universe of eligible securities that excludes certain selections such as real estate investment trusts (REITs), preferred/convertible securities or securities below a certain market capitalization level. Committees may then feed the universe constituents into a primarily quantitative model that screens variables such as yield, dividend growth rate, return-on-equity and other factors against predetermined thresholds. Securities that aren t filtered out by the screen are then usually ranked by a factor, often yield, with the top-ranked securities forming the index after preset weighting limits are applied at security and sector levels. A dividend ETF may then apply additional quantitative screens and limits to eliminate or overweight respective securities from the target index. The ETFs tend to parallel the monitoring frequency of the indices, with holdings reviews often occurring only quarterly or annually. 1 Source: ETFdb.com, December 2017. NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

The passive screening process that a dividend ETF adopts may be more or less sophisticated, but broadly speaking, such screens are limited by their very nature. For instance, many screens are backward-looking over long periods and are therefore fundamentally not nimble enough to capture recent dividend developments. Such developments may include a company initiating a dividend, or a firm spinning off a new dividend-paying entity. Short- to medium-term trends that passively lead ETFs to relatively heavy or light geography/sector/industry exposures may also be missed, undermining diversification. The aforementioned long intervals between reviews also highlights that reaction time may be slow; many materially important events can transpire in a given quarter. Exhibit 1: The Quickly-Changing Dividend Environment Select Dividend Developments by S&P 500 Sector, as of December 31, 2017 Sector Number of Dividend Payers Post Financial Crisis* Dividend Growth Over Last 5 Years Number of Dividend Payers Today** Forecasted Dividend Growth Through 2019*** Consumer Discretionary 48 16.5% 63 7.8% Consumer Staples 39 8.2% 33 6.8% Energy 32 10.3% 29 5.2% Financials 67 22.9% 64 15.1% Health Care 23 10.9% 35 6.5% Industrials 53 13.6% 63 4.9% Information Technology 29 23.1% 46 7.3% Materials 27 13.7% 24 5.1% Real Estate -.- 11.3% 31 6.4% Telecom 6 2.3% 3 2.1% Utilities 32 4.9% 28 6.3% Source: FactSet as of 12/31/17. S&P 500 sectors classified using the S&P Global Industry Classification Standards (GICS). Past performance is no guarantee of future results. *As of 12/31/09. The Real Estate sector inception occurred in 2016 and historical data is not available. ** As of 12/31/17. ***Forecasted dividend growth data is based on Wall Street consensus estimates. In some cases, company forecasted dividend growth data are only available through 2018, but have been included in the calculation above. Many ETFs employ backward-looking screens over long periods, which may NOT BE FUNDAMENTALLY NIMBLE ENOUGH to capture recent dividend developments. A Focus on Market Events Rather Than Quality Alternatively, ETFs can also be too quick to act. Companies that announce a dividend cut may trigger a knee-jerk elimination by an ETF, with no consideration of extenuating factors. This can generate highly increased ETF turnover during difficult markets. Mitigating circumstances may make it more effective to carefully manage exposure to a dividend-cutting company rather than eliminate it completely, but ETF mechanics may not allow for such nuanced approaches. Because the ETF screening process is generally reactive, a company s decision to engage in a negative dividend action such as a cut or elimination may not be anticipated and the effects thereby deftly avoided. Instead, ETFs may be forced to accept available prices during a time of selling pressure following a company s announcement of adverse news. The reactionary nature of some dividend ETFs is also underscored by the fact that they only came into existence relatively recently, in response to increased dividend focus by 2

investors. These unseasoned investment vehicles haven t yet been tested by the challenges of a grinding bear market. ETF Exclusivity Dividend ETFs sometimes require a decade or more of consecutively growing dividend payments for a company to be considered for inclusion. Since around three-quarters of S&P 500 Index companies haven t increased their dividends for at least 10 consecutive years, S&P 500-based ETFs that require such consistent hikes have an accordingly restricted investable universe. Dividend ETFs also sometimes require held companies to yield above a certain threshold, e.g. 2%. Since more than one-third of S&P 500 companies yield below that level, the opportunity set is once again arbitrarily narrowed. Exhibit 2: Greater Investment Universe Percent of S&P 500 Index Companies by Consecutive Years of Dividend Increases (as of 12/31/17) 25% 55% Recent Dividend Growers (Less Than 10 Years) Mature Dividend Growers (Greater Than 10 Years) All Other S&P 500 Companies* Companies by Dividend Yield (as of 12/31/17) 45% 35% Below-Market Yielders (Less Than ~1.9%) Above-Market Yielders (Greater Than ~1.9%) All Other S&P 500 Companies* * Includes non-dividend payers and those that cut their dividend during the period. Source: FactSet as of 12/31/17. Past performance is not indicative of future results. Different indices and economic periods will produce different results. Index returns include reinvestment of income and do not reflect investment advisory and other fees that would reduce performance in an actual client account. Indices are unmanaged and unavailable for direct investment. ETFs rules-based models that require mature dividend growers or above-market yielders have a LIMITED INVESTABLE UNIVERSE Only 25% of S&P 500 companies have increased their dividend for at least 10 consecutive years Less than half of the companies in the S&P 500 currently generate a dividend yield greater than the S&P 500's yield of ~ 1.9% Not All That Matters Can Be Measured The quantitative focus of dividend ETF construction can make these funds blind to important elements indicating the long-term quality of securities. Despite many attempts to create quantitative models that fully account for the qualitative, some important factors like effectiveness of execution, management s level of dividend prioritization and competitive prospects simply can t be modeled in a numerical, cardinal fashion. These elements can have significant impacts on the growth and sustainability of dividends, but ETFs are structurally unable to consider them. Dividend ETFs may also engage in opaque operations that quietly increase risk to investors. For example, ETFs may lend their securities to third parties in an effort to secure more income. This can create exposure to counterparty risks that investors may not expect. Some ETFs may also invest in securities or derivatives outside of their target indices, causing them to track their index less faithfully than investors may have anticipated 3

( tracking error ). Even if an ETF keeps to index selections, though, if the target index contains thinly-traded securities, the ETF can t buy them without substantially pushing up their prices due to typical trade sizes. This forces the ETF to use a sample containing the more liquid securities to proxy the index. Such a proxy may not track the index particularly close, and this tracking error can be amplified during periods of high market volatility. In fact, a study by Morgan Stanley found that the average tracking error for U.S.-listed ETFs (excluding inverse and leveraged versions) was a tremendous 0.52% during the tumultuous year of 2008. 2 Investors may want to carefully consider what it means to faithfully track an index, however. ETFs are often marketed on the premise that their rules-based model removes emotion and creates consistency through varying market conditions. Analyzing their portfolios over time, each of the largest dividend ETFs by assets have had periods of substantial concentration in individual sectors. ETFs of this type tend to favor higheryielding securities but neglect company fundamentals, valuation and the economic environment. For instance, during the third quarter of 2008 each of the ETFs had a larger weight in the Financials sector than the S&P 500 Index. An extreme example, the third largest dividend ETF had almost two-thirds of the portfolio allocated to the Exhibit 3: The Evolution of Sector Weightings The Largest Dividend ETFs by Assets from December 31, 2007 to December 31, 2017 10 4 3 1 Largest Dividend ETF Sector Weightings Second Largest Dividend ETF Sector Weightings 10 4 3 1 12/07 12/08 12/09 12/10 12/11 12/12 12/13 12/14 12/15 12/16 12/17 12/07 12/08 12/09 12/10 12/11 12/12 12/13 12/14 12/15 12/16 12/17 Third Largest Dividend ETF Sector Weightings Fourth Largest Dividend ETF Sector Weightings 10 10 4 4 3 3 1 1 12/07 12/08 12/09 12/10 12/11 12/12 12/13 12/14 12/15 12/16 12/17 12/07 12/08 12/09 12/10 12/11 12/12 12/13 12/14 12/15 12/16 12/17 Utilities Telecom. Materials Information Technology Industrials Health Care Financials Energy Consumer Staples Consumer Discretionary Utilities Telecom. Real Estate Materials Information Technology Industrials Health Care Financials Energy Consumer Staples Consumer Discretionary Source: FactSet as of 12/31/17. The largest Dividend ETF is based on the Vanguard Dividend Appreciation ETF (Ticker: VIG), the second largest Dividend ETF is based on the Vanguard High Dividend Yield ETF (Ticker: VYM), the third largest Dividend ETF is based on ishares Select Dividend ETF (Ticker: DVY) and the fourth largest Dividend ETF is based on SPDR S&P Dividend ETF (Ticker: SDY). 2 Sources: Morgan Stanley Research, ETF Providers and Trusteess and Bloomberg, February 2010. 4

Financials and Utilities sectors. More recently, many of the largest dividend ETFs have favored sectors such as Consumer Staples and Utilities. 3 Conclusion No investment vehicle is always perfect for all investors, just as no vehicle is always a poor choice for all investors. A dividend ETF may well have a place in a given investor s portfolio. In a rapidly changing economic and political environment, we believe it's important to consider all material factors when analyzing the numerous investment choices available today. In our view, a fully informed investor is much more prepared to manage the lions, tigers and bears lurking on even the most delightful yellowbrick road! 3 Source: FactSet, December 31, 2017. For more information, please contact your financial advisor and visit nuveen.com or contact Santa Barbara by visiting sbasset.com. GLOSSARY A Dividend ETF is any exchange-traded fund that seeks to provide high yields by investing in a basket of high-dividend-paying common stocks, preferred stocks or REITs. There are dividend ETFs that contain only U.S. domestic stocks and global dividend ETFs, which have an international focus. Dividend Growth Rate represents the percentage increase in the annualized dividend payment over the reflected time period. Dividend Yield for a company's stock, the ratio of the dividends paid out by the company each year per share to the share's current market price. An ETF, or exchange-traded fund, is a marketable security that tracks an index, a commodity, bonds, or a basket of assets like an index fund. Unlike mutual funds, an ETF trades like a common stock on a stock exchange. Least-Squares Regression is a statistical method used to determine the line of best fit for a set of paired data. Tracking Error is simply the standard deviation of a portfolio s relative returns (relative to some benchmark). Whereas the standard risk measure of standard deviation measures the absolute return volatility, tracking error measures the volatility of the return differences between the portfolio and the benchmark over time. A portfolio that is actively managed in an aggressive manner would have a large amount of tracking error versus its index, whereas a portfolio that is more constrained to look like its index (an index fund being the extreme) would have smaller amounts of tracking error. Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. Yield is the rate of return on an investment expressed as a percentage. RISKS AND OTHER IMPORTANT CONSIDERATIONS This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor's objectives and circumstances and in consultation with his or her advisors. This commentary should not be relied upon as investment advice, recommendations, offers or solicitation of any particular security, asset class, fund, strategy, or investment product. Investing entails risk, including the possible loss of principal. There can be no assurance that any investment or asset class will provide positive performance over any period of time. Dividend yield is one component of performance and should not be the only consideration for investment. Dividends are not guaranteed and will fluctuate. Equity investments such as largecap stocks are subject to market risk or the risk of decline in response Santa Barbara Asset Management, LLC is a registered investment adviser and an affiliate of Nuveen, LLC. to adverse company news, industry developments, or a general economic decline. Past performance does not guarantee future results. This report is provided for informational and educational purposes only, and should not be construed as specific investment, financial or business advice. The statements contained herein reflect the opinions of Santa Barbara Asset Management, LLC ( Santa Barbara ) as of the date written. Certain statements are forward looking and/or based on current expectations, projections, and information currently available to Santa Barbara. Such statements may or may not be accurate over the long-term. While we believe we have a reasonable basis for our comments and we have confidence in our opinions, actual results may differ from those we anticipate. We cannot assure future results and disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Statistical data was taken from sources which we deem to be reliable, but their accuracy cannot be guaranteed. 427000-INV-Y-02/19 GPE-BBETA-0218P Nuveen 333 West Wacker Drive Chicago, IL 60606 800.752.8700 nuveen.com