The iShares Select Dividend ETF (ticker: DVY) is income royalty in the exchange-traded fund world. It’s the third-largest dividend-focused ETF on the market at $16.8 billion in assets under management, and the top dividend equity fund in the iShares stable.
And perhaps most impressively, it has matched the Standard & Poor’s 500 index in total returns since inception in November 2003 — a feat few index funds, fund managers and hedge funds can boast.
However, dividend investing is coming to a crossroads of sorts in 2017, and the venerable DVY and its portfolio of its higher-yielding blue chips may suddenly find itself in an unenviable position.
Breaking down the DVY. The iShares Select Dividend ETF tracks an index “composed of relatively high dividend paying U.S. equities,” as its provider page reads. “Relatively” is an important term, because DVY’s 3 percent yield isn’t what most investors would call “high” … but it is generous compared to many blue-chip stock funds.
[See: The 25 Best Blue-Chip Stocks to Buy for 2017.]
The index is comprised of Dow Jones U.S. Index constituents that pass a number of quality screens, including a $1 billion minimum market capitalization, non-negative trailing 12-month earnings and a non-negative historical five-year dividend-per-share growth rate. This produces a 100-stock portfolio of big-name blue chips such as Lockheed Martin Corp. ( LMT), McDonald’s Corp. ( MCD) and Chevron Corp. ( CVX), but also a few lesser-known names with higher-quality dividends, such as Packaging Corp. of America ( PKG) and CME Group ( CME).
While the DVY boasts double-digits weights in financials (15 percent), industrials (12 percent) and consumer discretionary (11 percent), the biggest chunk of the fund is dedicated to utilities, which account for 28 percent of the ETF’s assets.
That heavy weighting in utilities has been a point of strength for the DVY — but going forward, it could be its Achilles heel.
The income environment is shifting. The market got exactly what it thought was coming in late December 2016 when the Federal Reserve doled out its first interest-rate hike since December 2015, and only its second in a decade. No surprise there, but what gave dividend investors a little pause was the forecast for three rate increases in 2017.
“Continual raising of interest rates back to some normalized interest rate level is going to be a headwind for any higher-yielding asset class, including dividend-paying stocks,” says Mike Akins, senior vice president and head of ETFs at ALPS, a Denver-based asset servicer and management solution provider. “Generally speaking, though, if you look historically, individual dividend-paying companies have done just fine during rising interest rates. What it comes down to is, how do interest rates affect various sectors?”
If you hold DVY, you should be awfully interested in how interest rates affect utilities.
“Utilities don’t really have earnings growth, so they can’t support a growing dividend to compete with higher and higher interest rates from the bond market,” says Eric Ervin, president and CEO of Reality Shares, an investment company in San Diego. “That’s usually when they suffer.”
Ervin, who points out that utilities’ nearly 30 percent makeup in the DVY is “a pretty big overweight,” offers up the example of 2016, where utilities ran through the first seven or eight months of the year as the rate-hike can was kicked down the road, but plunged as an increase before year’s end became increasingly inevitable.
Akins sees utilities’ problem as twofold.
[See: 7 Dividend ETFs for the Income-Minded Investor.]
“You have to look at utilities as a bond proxy sector. Right or wrong, it’s been used that way for a long time, so to that extent … (a rate hike is) going to hurt the premium of those stocks,” he says. “Second, some of these sectors versus their historical averages are trading very rich right now because we’ve been in such a cheap environment, a yield-starved environment.”
To get an idea of how rich, look at the Utilities SPDR ETF ( XLU), which trades for more than 21 times earnings even after a high-single-digit cool-off from its summer 2016 highs.
Arturo Neto, chief investment strategist at Coral Gables, Florida-based Orenda Partners, says the market will start to see a rotation within dividend investing, and that high-dividend assets as a whole are becoming overvalued.
Instead, right now might be the time to ditch funds like DVY with a focus on higher income, and adopt a different strategy instead.
Stay safe with quality and growth. The stocks that are most at risk in a rising-rate environment are those where a decent dividend is one of the main selling points. A company with a 3 percent yield but middling growth prospects and stingy dividend appreciation begins to look far less attractive when U.S. Treasurys throw off increasingly more income.
That’s when investors should put more of an onus on the quality of the dividend — which includes dividend growth — and of the core business in general.
“Our recommendation has not necessarily been to slam on the brakes, but to take profits on some of those (high-income) dividend ETFs and put money into the dividend grower ETFs,” Ervin says. “Then you’re doing twofold. You’ve got the higher quality, and in a higher-valuation environment, you want to have more quality in your portfolio just in case there’s a correction. But two, if interest rates start to rise, you have this rising income stream and you’re not necessarily beating up your total return.”
Neto echoed that sentiment, suggesting investors focus on stocks that are growing their payouts faster than higher-yielding stocks and greatly outpacing inflation.
“I prefer to focus on ETFs like the Vanguard Dividend Appreciation ETF ( VIG) that focuses on companies that have increased their payouts on a regular basis,” he says. “Its dividend yield is only 2 percent or so, but the important factor to consider is that the dividend payouts of the underlying companies are expected to increase.
The S&P 500 Dividend Aristocrats ETF ( NOBL) — which features funds that have increased payouts for at least 25 consecutive years — is another option. “Only the most stable companies tend to have that kind of record,” Neto says.
Does that mean DVY should go out the window? Not necessarily — over the very long-term, DVY is a proven winner that managed to churn out strong gains in its first few years amid a rising-rate environment.
Still, DVY’s overweight in higher-yield but expensive utilities could hold the fund back for the time being.
[Read: Why You Should Own Dividend Stocks.]
“I think people need to back off, take profits, be grateful for all the gifts they’ve been given,” Ervin says. “And shift into those higher-quality, lower-gross-dividend-yield stocks.”
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DVY: Are High-Income Blue Chips in Trouble? originally appeared on usnews.com
