The Hunt for Yield Part Three: Getting dividends is easy, picking the right ETF is hard.

Charles Booker said there were only seven basic plots in literature; turns out the same is true for ETF’s, they just have billions more to spend on advertising. 

-The Yinzer Analyst. 

If you’ve been beaten over the head with one investment theme in 2016, it’s that you need dividends.  Some want the income stream and the low volatility, some want the capital gains from the first group buying up dividend stocks and others just want their annoying clients to go away and think buying yield is a good way to make that happen.  We’ve already talked about why dividends aren’t likely to continue growing at the same rate in the future and what dividend payers are still “cheap” in this market but now comes the hard part, finding a good fund wrapper to buy them in.  Unfortunately for many investors, that means buying an ETF and then forgetting it, but I haven’t come to either bury ETF’s or praise them.  Instead I want to educate investors so they can avoid doing the one thing that will guarantee them a spot in the next Dalbar study; buying something that’s already expensive because they’re afraid and think it’ll solve all their problems. 

After all, what are ETF’s but trading vehicles created (or at least marketed) as a cure for whatever ails you.  Worried about picking that right manager and underperforming the market?  No problem, we have a fund that can track any index you want and it’ll never underperform by more than the small fee we’ll charge.  Need a fund to track a single industry, or country or even just one particular factor (looking at you low vol)?  We got your back.  And remember, every active manager will charge you a bunch of hidden fee’s so your chances of outperforming the market in the long-run are very small so why even bother trying?

ETF’s may have been started as a way to simplify investing but by becoming the Baskin Robbins of investment products and through working in tandem with the rise of the “beating the benchmark attitude” all they have done is INCREASE the number of active decisions investors need to consider and making it even easier for them to stampede into a herd when trouble comes.  You may think I’m exaggerating or going all Zero Hedge to up my page views, but my concerns come down to two basic problems.

  1. The five largest dividend-focused ETF’s on ETF Global’s list have had a net inflow of $5.6 billion in new assets YTD through 7/22 but that’s a drop in the bucket considering they now have over $76 billion in assets and still more $1 billion behind what the iShares MSCI Low Volatility ETF (USMV) has pulled in this year. Not a problem except that high dividend and low volatility funds tend to cluster in several sector, chiefly utilities and consumer staples, which are now incredibly expensive relative to their own history meaning funds holding those names are trading at record high multiples.  Even a slight shift in the market dynamic could have dire consequences.
  2. The relative calm following the Brexit vote has reignited chatter about whether the Fed might need to contemplate a rate hike later this year. Equities making new highs even as earnings decline has pushed the trailing P/E multiple into “irrational exuberance” territory and the Fed’s mandate to “keep the economy calm and carry on” may mean having to tighten monetary policy to pull the wind from the sails.  If this does happen, interest rate sensitive sectors like utilities could be in for a bad time.

Before you fall into a panic, you need to remember a few key facts including that low volatility stocks and dividend payers (which are often one in the same but not always) do tend to outperform over long periods of time, but not when purchased at outrageous prices.  Secondly, that in the last year that performance differential between the best and worst fund in the high dividend space is over 2600 bps because again, NOT ALL ETF’s ARE CREATED EQUAL.  So what we need to do next is consider the top 3 and bottom 3 performing ETF’s to find out what makes them tick, to see what agrees with my re-run list of cheap stocks, and find out if they can offer a viable alternative for investors.

If you got money problems I feel bad for you son.  I got 99 problems, but getting yield ain’t one. 

Let’s start this review by stating the obvious, investors aren’t not hurting for options when it comes to high dividend funds.  There may be exactly one fund devoted to the automobile industry but ETF Global shows 26 unlevered, long-only funds devoted to just U.S. equities and with roughly the same amount in assets as Ukraine’s GDP which is still a drop in the $2 trillion in assets invested through ETFs.  Still, they all have low fee’s and an average yield more than 40% of the S&P’s and some even have track records going back to 2003 so doesn’t sound like it should be that hard to pick a fund except for one tiny little thing.  Their performance is all over the map with the PowerShares S&P 500 High Dividend Low Volatility Portfolio (SPHD) up 28.81% over the last year while the First Trust NASDAQ Rising Dividend Achievers (RDVY) is down .64%.

So maybe it’s not so easy after all which is why you need the Yinzer Analyst to help you find the way and the first thing you should know is that even with $80+billion in assets between then, those 26 funds are all just variations on the same theme.  What that means is up until a point, they follow a very easy-to-identify process:

  1. Define a universe of stocks to pick from
  2. Put together a mechanical screen to select securities – in this case, based around dividend yield/income and whether they are sustainable.
  3. Add a weighting system
  4. Pick a date(s) to reconstitute/rebalance the fund so you can add all those stocks that made the screen and cut out those who didn’t.

And that’s the entire process in a nutshell and while that sounds very mechanical, that’s exactly what you would expect from a passive fund.  I hate using this expression, but screening actively run funds is more “art than science.”  It’s like being a detective; you have a performance history, some fund documents, maybe an attribution report but ultimately you have to ask questions to get to the truth of what they bought and sold and eventually you have to make a leap of faith that the manager can deliver on their promise.  Screening ETF’s is much more scientific, like doing an autopsy with no need to ask questions of a manager since the portfolio history derived from a set of rules, not a person making decisions.

In some ways, designing an ETF benchmark is essentially just building a better mousetrap so why not pick the one that’s done the best this year and be done with it?  Because if you don’t understand the rules that went into designing the benchmark, you’ll never know how the fund will “respond” when the market shifts.  An active fund could hold additional cash, shift sectors, even style drift over time but an ETF can’t do any of that.  Plus, I already assembled a lot of information from different sources so this is happening, just go with it.

However, to keep things simple, we’re going to look at the top three and bottom three performing funds over the last year to determine what went right, wrong or could change in the future but let me explain the process before we begin.

  1. The list of funds was provided by ETF Global since Morningstar doesn’t have a category for high dividend funds and instead lumps them into whatever style box they fit into. Most of these funds would be “large value.”
  2. The focus is not on finding matching names from my list of cheap stocks or a comparable yield/earnings yield system I used.
  3. We’re also not comparing individual holding performance beyond a few examples but looking at how each fund got into the top or bottom rungs this year.
  4. This information was assembled for a lot of different places (see the sources at the bottom of each chart) so some data might be as of 6.30.16 while other information might be as of 7.24.16. As always, if you have questions, leave a comment.  If you worried about your portfolio, find an advisor.

First up, you have three funds that have just been killing it over the last year, SPHD, the First Trust Morningstar Dividend Leaders Index Fund (FDL) and the PowerShares High Yield Equity Dividend Achievers Portfolio (PEY.)  You can see from the chart that the S&P 500 is up a little over 4.3% in the last year but these three funds are stone…cold….killers each up over 20% with FDL being the sluggard at up just over 24%.

DIV PERF

Not bad but how’d they get here?  Start with the chart below for the winners and then skip to the end to compare it with the chart for the biggest losers:

(click to blow up)

DIV COMP

What’s the first thing you notice?  Yes, the winners have higher exposure to defensive sectors like utilities and consumer staples and heck, even materials and tech stocks have done better than the broader market over the last year.  The real problem has been healthcare stocks (15% of the market) and financials (14%) that have been acting as a drag on the broader S&P.  But remember, looking at the sector weightings is like studying the symptoms and not asking what caused them.  There was no active manager making that call to overweight utilities, so how’d they get those allocations?

Start by comparing their strategies and you’ll notice that the funds who have been killing it over the last year have about as basic a strategy as you can come up with and using the KISS system has led to some excellent results.  My tables just focus on the dividend rules and leave out a lot of the material on liquidity like trade volumes but essentially, the three top performers pick the highest yielding names without much regard where it’s located beyond not being a REIT and even SPHD doesn’t go that far.  Focusing on the biggest winner, SPHD starts off with screening the S&P 500 for 75 stocks with the highest dividend yield and then picking the 50 with the lowest volatility.  Fairly straightforward and easy to do twice a year and so far it’s worked with the fund in the top 1 percentile on a 1 and 3-year basis with a standard deviation that’s lower than the S&P 500.  But did you notice what’s missing from that?

What jumped out to me from looking at SPHD was that there is nothing in the prospectus about how sustainable those dividends are.  The focus is on finding high dividend yields, not on finding great companies that also offer attractive yields!  Unlike my screen that used high earnings yield (or you could say a low P/E ratio) to determine sustainability, SPHD simply looks for the S&P 500 components with the highest payouts relative to their price.  Seems like a pretty big oversight destined to lead to all sorts of beaten up stocks making their way into the mix!

The counterargument has been that S&P 500 components that start cutting their dividend usually don’t stay in the S&P for very long but you can see that several holdings in SPHD have extreme P/E ratios with two of its strongest performers over the last year, Spectra Energy and Iron Mountain, having P/E ratios of 152 and 59 respectively according to Morningstar.  Now most investors don’t care about where their dividends are coming from, but they should care if they can be maintained going forward and that’s something that might be in doubt at both companies.  Spectra energy’s payout ratio is over 627% according to Finviz (for a coverage ratio of .15) while Iron Mountain is around 279% so whether they can sustain their dividends without strong earnings growth is in doubt.

FDL and PEY have a similar philosophy on screening based on dividend yield but they do incorporate sustainability into their processes.  FDL starts building its index around a very broad universe from which they eliminate all non-dividend payers and then focusing on those whose dividends have grown over the trailing five years and with a dividend coverage (the inverse of the payout ratio) greater than 1 (or a payout ratio of .5 or below.)  You’ll notice there’s nothing in there about valuations but requiring growing dividends and a reasonable payout ratio excludes a lot of the more troubled names.  There’s no Iron Mountain or Spectra here although FDL’s broader universe gives it a wider pool of candidates to choose from.

PEY, which like SPHD is a Powershares Product although with a different index provider, has a different approach.  There’s no specified payout ratio but instead they require ten years of consistent dividend increases to make the benchmark and if you want to know how hard that is, the answer is very.  It’s benchmark, the NASDAQ US Dividend Achievers 50 Index or DAY is drawn from the 50 highest yielding stocks in the NASDAQ US Broad Dividend Achievers Index, which is where the ten years of consistent growth filter meets the broader NASDAQ U.S. Benchmark.  2700+ stocks go in, just 274 make the Dividend Achievers index.

But finding great stocks is just step 2 of 4, next you have to figure out how you weight them and all three of the great performers use a dividend oriented approach compared to the optimized or equal weighted approach employed by the underperformers.  SPHD and PEY focus on dividend yield which is fairly straightforward with either the biggest payers (or the cheapest stocks) getting a larger piece of pie but it’s not without its risks.  The biggest dividend yields often come from companies in some sort of financial distress with investors selling-out before dividends are cut in the future, leaving a substantially higher yield today but with low sustainability and while also producing a deep-value portfolio.  You can see this with SPHD where Iron Mountain and Spectra are the 1st and 3rd largest positions respectively with CenturyLink Telecom sitting between them and with a 128% payout.  PEY also uses a straight dividend yield approach but pulls its stocks from a broader universe, reducing overlap with SPHD while giving it a more mid-cap feel.

FDL is different, focusing on what Morningstar calls:

 Dividend dollar-weighted indexes are those where the constituents are weighted according to the total dividends paid by the company to investors. Consequently, the available dividend dollar value is the product of the security’s shares outstanding, free float factor, and annualized dividend per share.

–     Morningstar Indexes Calculation Methodology, January 2016

The net effect of focusing on the total amount of cash being paid out is to produce a radically different portfolio from SPHD or PEY; like those two it has an almost deep value feel although with an entirely different make-up.  Because of their sheer size and the amount of capital they return, telecom stocks are the largest two positions in the fund with AT&T and Verizon being the two largest positions at over 19% of the portfolio with the top ten making up over 60% of the total portfolio.

Now let’s contrast this with the worst underperformers over the last year:

(click to blow up)

DIV COMP2

First we’ll start with the obvious and you’ll notice that the FlexShares Quality Dividend Dynamic Index Fund (QDYN) and the First Trust NASDAQ Rising Dividend Achievers (RDVY) having an almost completely different portfolio make-up than our top performers with QDYN having substantially less exposure to defensive stocks than any of those three or even the Russell 1000 Value while RDVY has almost none whatsoever!  The culprits are a screening process so rigorous that it was easier just to cut and paste them from the prospectuses rather than trying to summarize it myself.

First of all, I’m expecting an angry letter from Northern Trust for even referring to QDYN as a dividend income fund since its goal isn’t to specifically to generate a stable income stream.  In fact, a tremendous amount of effort is spent at NT screening their “parent index” of 1250 large and mid-cap names who already have an income focus into a more manageable list of companies with even higher payouts but also profitability, cash flow and stable management.  It would seem like focusing on dividends really is just a profitable tool for screening financial discipline.  Even the weighting system is more complex as the goal is to produce a volatility (measured by beta) that’s GREATER than that of the parent index so the weights aren’t the product of a simple formula like an equally weighted system.  The net effect is where the top three performers all had an almost deep value feel to their portfolio’s, QDYN is a more traditional large-value to large-blend portfolio that can be used as a core holding and also just happens to have a higher dividend yield than other funds in the space.

Next comes what might be my favorite fund of the bunch, the First Trust NASDAQ Rising Dividend Achievers fund, which has a screening system so complex that you know I just cut and pasted it.  It’s easiest to compare RDVY to PEY since NASDAQ is the index provider for both but where PEY’s benchmark is built around the fifty highest dividend yielders from NASDAQ stocks that have paid consistently higher dividends over the last ten years, RDVY focuses on sustainability with not just positive EPS over a three-year period but also a cash-to-debt ratio of at least .5 and a payout ratio below .65.

What that gets you is a portfolio very similar to that I put together at the start of this series, with a strong showing by financial stocks and retailers with RDVY’s current largest position being The Gap, which has a cash-to-debt ratio around .76 and a payout ratio of .46.  In fact, Morningstar says the fund’s price multiples are consistently below that of the rest of the space while it’s posting stronger historical earnings than other large value funds.

Then again, if you’re in business to make money, running RDVY hasn’t been a great way to go about doing it as the lack of any defensive names combined with heavy exposure to the worst performing sector means that RDVY isn’t on the top of anyone’s watch-list.  And unlike PEY, RDVY uses an equally-weighted allocation meaning all 50 names are given 2% of the pie when the fund is rebalanced which is one reason why RDVY’s yield is only 2.6% compared to 3.2% for PEY which focuses on higher dividend payouts.

Mo Dividends, Mo Problems

But if you’re looking for straight dividends and don’t care how the job gets done, thank your lucky stars for whoever dreamed up our sixth and final fund, the Global X SuperDividend U.S. ETF (DIV) because if funds sporting 2.6% or 3.2% yields don’t get you worked up, DIV will get your blood boiling with its 7.4% yield!  But how it gets there is by having a selection process that is completely different than anything else we’ve seen yet.  What’s in the secret sauce?  A willingness to turn the Benjamin Graham/Warren Buffet playbook on its head.

First, their dividend screening rule is the loosest we’ve encountered.  Their index provider begins by scrubbing the universe (which is all stocks with a market cap above $500 million and an average daily trade volume of $1m) first by dividend yield and then looking for “consistent” dividend payers.  So how do you define “consistent?”  Five years, ten years?  Nope, over the last TWO years and instead of stable or rising, the current dividend payout (year two) has to be greater than or at least equal to, 50% of year one.  Not rising mind you, it just to be at least 50% or more of what it was.  They then exclude anyone who’s free float is less than 10% of shares outstanding, rank again by dividend yield with the top fifty making an equally weighted portfolio.

Most of the other funds in the space either have a $1 billion market cap floor or draw from indices with mostly large or mid-cap names and exclude REIT’s because their dividends aren’t qualified or because of their interest rate sensitivity, but if you’ve got yield, you have a home at DIV which is why they were also the only fund we screened here that accepts MLP’s in the portfolio.  MLP’s can make up to 20% of the portfolio while no other sector can by more than 25% and both are pushing their limits.  At the moment MLP’s are 11% of the portfolio while REIT’s are over 20%!

So an equally-weighted portfolio drawn from a broader universe of companies who’s dividends don’t actually have to be growing….just imagine what that gets you.  First is a heck of a yield not to mention an average market cap of just over $3.9 billion, just under a third of the fund with the next lowest average market cap, PEY.  You’re also getting a fund where you’ll see periods of noticeable underperformance like in 2015 when it was down 10.6% compared to a negative 5.46% for the large value category average and a positive 1.38% return for the S&P 500 but while the fund has underperformed over the last three years, it’s had less volatility over that period (per Morningstar) and has delivered slightly better returns than the broader market or category over the last year.

Remember, the industry spends billions on advertising, not on providing grief counselors in the event you buy the wrong fund which doesn’t do what you want.

So here we are, 3000 or so words later and the basic question still hasn’t been answered, which fund should you choose?  You were looking for a quick and easy answer on finding a fund to get you all the dividend exposure you could need and instead your head is swimming trying to consider all the pro’s and con’s of each fund.  Feel dazed and confused?  Congrats, that’s the world of investing with ETF’s.

Remember when we compared ETF’s to Baskin Robbins, there’s a 1000 flavors and no two are exactly the same but there’s no such thing as an inherently bad fund.  The only time I feel that’s true is when it comes to active managers who are really just closet indexers (see more about that here.)

Instead of focusing on which fund is the “best” we need to ask, what do you want from a dividend income fund?

My personal view on the subject is this:

  • If you’re looking to play the “buy defensive stocks” theme and aren’t concerned about whether the dividend is sustainable, check out SPHD. It’s made up of some of the most liquid stocks out there and reconstitutes itself twice a year.  Only QDYN reconstitutes itself more frequently but SPHD only charges .3% for that service!
  • If you really do need qualified dividend income and you’re somewhat concerned about sustainability, check out FDL or PEY. Both are excellent funds but you need to consider how the market might shift going forward.  If you expect rates to stay lower for the rest of this year, then FDL with a high utilities/low financials allocation might be best.  If the Fed does hike, PEY’s larger allocation to financials might compensate for losses in its utilities names.
  • If you like the idea of dividend stocks but you have a higher risk profile or want a higher yield or the potential for more capital gains then DIV might be right up your alley.
  • If you want yield and like the corporate discipline dictated by paying dividends but need a more traditional large value fund, QDYN should be on your watchlist.
  • Finally, if you’re like me and love dividends but think there’s the possibility the Fed could hike rates or even that investors could suddenly become equity risk averse and take profits in the utilities and staples sectors, then RDVY has the right allocation.

Each on these funds has attractive attributes which is why it’s so hard to say one is better than another, which is why I’ll be doing a follow-up posting later this week where I build my own mousetrap and put together the best features of all these funds into a new tracking strategy, mostly as a learning exercise as well as to hold me accountable to you.

ETFs may have been created as a solution to the time consuming process of finding great managers, but innovation can breed its own problems and the industry spends billions on advertising, not on providing grief counselors in the event you buy the wrong fund which doesn’t do what you want.  That’s why the fourth and final post in this series will be looking at actively run mutual funds to find those who have managed to capture the market’s upside while also getting income for investors.

Remember there are no mulligans in investing although one benefit of working with an advisor is you can scream at them when they lose you a bunch of money.

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