Why Doesn't The Dividend Growth ETF Grow Its Dividends?

Dec.16.13 | About: SPDR Dividend (SDY)

An article at Seeking Alpha making the case for the SPDR S&P Dividend ETF (NYSEARCA:SDY) had the following question left in the comments which as of the time I saw it had not been answered by anyone;

$SDY seems to be headed for a lower divi in 2013 compared to 2012. how is this possible if the stocks are supposed to increase divi each yr?

SDY tracks an index of domestic stocks that have raised their dividends for at least 20 years. The screen shot below captures almost all of the dividends ever paid by SDY (the fund goes back to late 2005).

You may need to zoom it to see, but it is pretty clear the dividend of the dividend growth ETF isn't growing, so what gives?

I stumbled into this in an article I wrote for theStreet.com earlier this year. There are two reasons I can come up with to account for why the dividend growth fund isn't growing its dividend. The first one is that the index's constituency can change over time. The index is constructed on growth not yield.

As a simplistic example, let's say SDY only had one stock. That stock had grown its dividend for 20 years and yielded 5%. Now let's say it had to cut its dividend, making it ineligible to stay in SDY. And let's say that at the same time the first stock was being kicked out, a new stock just qualified for inclusion into the index but that new stock only yielded 2%.

The yield of the index in that simplistic example would go from 5% to 2%. So now picture this sort of thing going on across the entire index which currently has 83 components. When I first wrote about SDY for the Street in 2006 it had a 25% weight in the financial sector compared to 16.44% now. Obviously a lot of financial stocks were booted out during the crisis, which no doubt plays some role in SDY's lack of growth in its dividend.

The other part of the equation is more of a market mechanics issue of how ETFs actually work. Again, with a simplistic example, let's say SDY owned 10,000 shares of Clorox (NYSE:CLX) on that stock's ex-date. The fund would get 10,000 shares worth of dividends which would be $7100. The fund would hold that accrued dividend to pay out on the fund's pay date for its dividend (the fund's ex-date and pay date will of course be different than that of the stocks it owns). Now let's say that between when fund receives its $7100 from Clorox and when the fund pays its dividend, the fund doubles in size. It will own 20,000 shares of Clorox but the most recent dividend was based on 10,000 shares, so the fund is paying out 10,000 shares worth of dividends to 20,000 owned shares.

The share count of an ETF changes all the time (creations and redemptions) and so as SDY grows (it is a successful fund) the effect of growing dividends can get eaten by the growing share count.

Disclosure: No positions