Equity income ETFs are preparing for what may be their biggest shake-up in years as scores of companies cut or suspend their dividends in the wake of the Covid-19 pandemic.

Dividend cuts are on track to surpass levels seen during the height of the financial crisis.

Globally, there is more than $200 billion in assets held within ETFs linked to dividend-based indices, and well in excess of 100 different ETFs, not counting cross-listings or related share classes.

Therefore, any decline in dividend payouts is going to affect a lot of portfolios.

But with global economic shutdown and the associated impact on consumer demand, companies are being forced to re-evaluate their cash flow in order to continue meeting debt obligations and avoid mass redundancies.

According to data from financial information giant and index provider S&P Global, 83 US companies (including REITs) have stopped paying dividends since the start of the year.

Many companies have been forced to suspend dividends as part of the conditions for receiving state support under the emergency CARES Act legislation.

In contrast, only 55 firms scrapped their payouts over the previous ten years (granted, this period covered the longest bull market on record).

Beyond these companies freezing dividends, another 142 have reduced the level of their payouts, on track to surpass the 316 dividend cuts experienced in 2009 at the height of the financial crisis.

Europe is experiencing a similar situation. Analysts at investment bank Citigroup stated at the end of March that earnings on the continent could shrink by as much as 50%. While dividends generally do not drop as much as earnings, Citigroup notes that payouts could fall by a third in line with the previous financial crisis.

Analysts at UK bank Barclays are less optimistic, predicting dividends within the pan-European STOXX 600 Index to be down roughly 40% this year.

The pandemic has affected every corner of the economy; however, many sectors that historically have offered high dividends have been particularly hard-hit.

Consumer discretionary stocks, unsurprisingly, have suffered the most suspensions, driven by firms operating within the hotels, restaurants, leisure, and specialty retail industries.

Many banks have also suspended dividends in a bid to boost their capital to loan ratios and prevent the virus from infecting the financial system with a credit crunch. The European Central Bank and Bank of England have gone so far as to order banks within their jurisdictions to freeze dividends, while the Federal Reserve has avoided going down that route so far.

The energy sector has seen cuts too, including from Royal Dutch Shell, the company’s first since World War Two. The oil industry is grappling with an unprecedented supply glut that has caused oil prices to plummet.

The consumer staples and healthcare sectors, known as reliable sources of dividends, have been relatively spared by the crisis as consumers stocked up on essentials at the beginning of the lockdown and the pandemic increased the likelihood of greater healthcare demand.

Regardless, the mass pullback in dividends has dealt a major blow to many ETF investors who rely on regular income streams. The importance of equities for these investors has risen in recent years as record low interest rates have driven bond yields down.

As the sheer volume of dividend cuts and suspensions become more apparent, investors will be wondering how their income ETF has been affected. As it turns out, this very much depends on the fund’s underlying strategy.

The vast majority of the one-hundred-plus dividend-focused ETFs on the market track distinct indices with different geographic exposures and/or subtly unique index methodologies and screening processes. Broadly, they can be broken down into two categories: those that focus solely on yield, and those that incorporate dividend sustainability.

As Matthew J. Bartolini, Head of SPDR Americas Research, State Street Global Advisors notes, this latter strategy, which also screens stocks for consistent dividend growth or quality balance sheets, has been more resilient during market downturns.

“Firms with consistent dividend growth over many different market cycles depict an aspect of capital discipline, more reliable cash flows, and more durable balance sheets relative to just pure high-yielding stocks,” said Bartolini. “In a bull market, those differences are less of a concern if all you are after is yield. However, in a bear market brought on by an exogenous crisis, today’s high yield might be gone tomorrow if cash flows are constrained – and that high dividend is cut to preserve capital.”

Amongst the largest dividend ETFs, there is a mix of strategies that focus solely on yield as well as those that add additional screening. The $25.2bn Vanguard High Dividend Yield ETF (VYM US) and the $12.9bn iShares Select Dividend ETF (DVY US), for example, focus solely on yield.

The Vanguard High Dividend Yield ETF tracks the FTSE High Dividend Yield Index. The index ranks US-listed, dividend-paying common stocks by dividend yield and selects the top-ranked securities that account for half the market capitalization of the eligible universe.

One of the largest dividend ETFs in Europe, the $2.1bn Vanguard FTSE All-World High Dividend Yield UCITS ETF (VHYA LN), utilizes a similar approach but applied to a universe of global stocks.

The iShares Select Dividend ETF is linked to the Dow Jones US Select Dividend Index which selects the 100 US stocks with the highest dividend yields that have made payouts for at least five years. The index is more aggressive, however, weighting constituents by dividend yield which increases income but may pull the fund towards riskier names with deteriorating fundamentals.

This may be especially true in the current environment where firms with collapsing stock prices (and consequently rising dividend yields) stand to have their weight increased.

By focusing solely on yield, these funds also leave open the possibility of including a greater number of smaller-cap stocks within their portfolios. Perhaps unsurprisingly, small-cap stocks have seen a higher number of dividend cuts and suspensions recently, reflecting the inconsistency of their cash flows. By contrast, large-cap stocks, with the stability that comes with mature multinational businesses and diverse revenue sources, have been relatively less affected.

Turning to sustainable dividend strategies, the biggest US-listed funds are the $41.0bn Vanguard Dividend Appreciation ETF (VIG US) and the 15.5bn SPDR S&P Dividend ETF (SDY US).

The Vanguard Dividend Appreciation ETF tracks the NASDAQ US Dividend Achievers Select Index which consists of US stocks that have increased their dividends for at least ten consecutive years. The SPDR S&P Dividend ETF is linked to the S&P High Yield Dividend Aristocrats Index which has the stricter requirement of at least 20 consecutive years of rising dividends for eligibility.

The largest dividend ETF in Europe is the $2.6bn SPDR S&P US Dividend Aristocrats UCITS ETF (UDVD LN) which tracks the same index as its US counterpart. The firm also offers the $1.5bn SPDR S&P Euro Dividend Aristocrats UCITS ETF (EUDI LN) which targets the 40 highest-yielding dividend payers within the eurozone that have increased dividends for at least ten years.

The allure of these funds is that they not only offer exposure to long-term, quality companies but also shield investors from the current impact of dividend cuts. So far, none of the 120 constituents within the S&P High Yield Dividend Aristocrats Index have suspended payments.

Long-time dividend-payers realize that by maintaining, or even increasing, their payouts they are sending a strong signal to the market about the resilience of their businesses during the current crisis.

Amongst the US Aristocrats, only four have decreased their dividends and are, therefore, at risk of being removed if they are unable to reverse course and raise their dividend later in the year.

The success of the strategy is, however, primarily evident in the performance figures. The SPDR S&P Dividend ETF (SDY US), which tracks the S&P High Yield Dividend Aristocrats Index is down -15.1% year-to-date, as of 29 April 2020, whereas the iShares Select Dividend ETF (DVY US), which tracks the Dow Jones US Select Dividend Index has fallen -20.1%. Moreover, the performance of the two funds notably began to diverge during the onset of the equity market sell-off, highlighting how a dividend sustainability strategy can offer portfolio resilience.

“From a broader market perspective, capital discipline has been noticeably rewarded in our current environment, as could be expected,” said Bartolini.

The performance difference between the two strategies highlights the importance of investors conducting appropriate due diligence to know exactly what’s under the hood of their ETF. With the timing of the pandemic’s end still uncertain, and scientists warning of the potential for a second wave of infections if restrictions are lifted too quickly, the dividend story is still unfolding

As Bartolini notes, “In today’s fast-paced news cycle, reliable information remains the key to decision-making.”