For much of the past couple of years, we’ve seen income investors abandon the fixed income markets and did their toes into the equities markets in search of higher yields. The Fed’s widely expected rate hike in December made those dividend yields look slightly less attractive. If the Fed’s forecast of three more hikes in 2017 comes to fruition, we may start to see a rotation out of dividend ETFs and back into fixed income.
With an improving outlook for fixed income yields and valuations on dividend stocks starting to look a little expensive, investors will want to approach their dividend ETFs with caution. Long term investors won’t want to abandon dividend ETFs altogether, just be a little more picky about where their dividends are coming from.
The ALPS Sector Dividend Dogs ETF (SDOG) targets the five highest yielding stocks from each of the ten GICS sectors (real estate is currently not considered) and equal weights them. The fund’s current yield of 3.3% far outweighs the S&P 500’s yield and constructs the portfolio in a way that doesn’t reach for dividend payers.
Many high dividend ETFs dig deep into the traditional income sectors like utilities and consumer goods & services to fill out their portfolios. The problem with that strategy in the current market environment is that valuations in those areas have become quite stretched. The Consumer Staples Sector ETF (XLP) and the Consumer Discretionary Sector ETF (XLY) both trade at forward P/E ratios of over 20 compared to the S&P 500’s (SPY) 18 multiple. The Utilities Sector ETF (XLU) trades at a multiple of 17, significantly above its historical average.
Given the equal sector weightings, the Dividend Dogs ETF has 30% allocated to these sectors. Some of the biggest dividend ETFs, such as the Vanguard Dividend Appreciation ETF (VIG) and ProShares S&P 500 Dividend Aristocrats ETF (NOBL) have more than 40% of assets in these areas. One of the biggest dividend ETFs, the iShares Select Dividend ETF (DVY) has more than 50%. Heavy investment in these areas exposes shareholders to downside risk, especially in an environment where Treasury rates are finally beginning to look more attractive.
Stocks targeted with the Dogs strategy tend to exhibit a few appealing characteristics. First, they tend to have stronger balance sheets with cash flows that can support higher dividends. Going after higher yields does have the potential of getting investors into trouble if a distressed company with an artificially high yield sneaks its way into the portfolio. By and large, though, the companies in this ETF are big revenue generators with enough cash to maintain and grow dividend payments.
Another advantage is the tilt towards value the portfolio tends to have. Since dividend yield is a function of price, many high yielders often have deflated stock prices. The Dividend Dogs ETF currently has a forward P/E of around 14 making it significantly cheaper than the broader market. Value outperformed growth in 2016 following two straight years of lagging returns. Value could be poised to lead the way again in 2017 amid uncertainties surrounding potential new government economic policies, the long term impact of Brexit, foreign relations and a richly priced equity market.
The Dividend Dogs strategy has performed very well historically. Investing in the Dogs of the Dow at the beginning of every year would have produced an average annual return of around 8% since 2000 compared to a 6% return for the broader Dow Jones index. The Dogs of the Dow have also outperformed the DJIA in each of the past four years. The Dividend Dogs ETF targets the S&P 500 instead of the DJIA but has delivered similar results. Since the fund’s inception in 2012, it has returned a total of 99% compared to an 83% return for the S&P 500.
2017 looks to be a year in which investors who are a little pickier about their sources of dividend income will benefit most. The dividend dogs strategy is one that has proven to work and in a variety of economic environments. The broadly diversified nature of this ETF along with its value tilt, its five-year record of steady quarterly dividend growth and its 3.3% dividend yield make it an ideal target for income investors in the new year.
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