Don't Count On Dividend ETFs To Play Defense

by: David Fabian


Dividend ETFs don't historically hold up better during times to market sell-offs.

While these tools provide excellent income, they may not be a safe harbor during a protracted downtrend.

Other risk management strategies, such as consumer staples, low volatility indexes, and fixed income may be better alternatives.

Many investors consider dividend ETFs to be safer than growth-oriented stocks. The perceived benefit from a consistent income stream is deemed to be more desirable than just riding out a steep drop without getting paid for the adventure.

Dividend-paying companies are also considered to be in a more mature phase of their business cycle, which paints them as anchors of stability in a storm of chaos. The fact that they can afford to pay back shareholders from profits must mean that their business models are quite sound.

However, the results of back-testing through extreme market conditions seem to uncover a mixed bag in terms of drawdown. In fact, ETFs that track dividend-paying stocks can often be just as volatile as a traditional broad market index.

Looking at two different time frames in recent memory, the 2008 financial crisis and 2011 market drop both offered some interesting perspective on risk management. Namely that ETFs dedicated to equity income are not necessarily a safe harbor when volatility ramps up.

The following chart illustrates the how the three largest dividend-paying ETFs performed versus the SPDR S&P 500 Trust ETF (NYSEARCA:SPY) from January 1, 2008 to March 6, 2009.

As you can see, the Vanguard Dividend Appreciation ETF (NYSEARCA:VIG) and SPDR Dividend ETF (NYSEARCA:SDY) had slightly better returns than the market, while the iShares Select Dividend ETF (NYSEARCA:DVY) actually fell more than its peers. All told, none of these funds outperformed significantly enough to consider them a safer alternative during a period of extreme duress.

The 2011 time frame, while albeit a much shallower and quicker drop, yielded similar results. Each of the dividend ETFs traveled a similar course to the broader market, with very little differences among the group.

Granted, there is some embedded selection bias in the time frames used in these drawdown examples. There were periods during 2008 when each of these dividend ETFs were outperforming the market for a short period of time.

Ultimately, these results reinforce the notion that dividend ETFs are not built for defense. Instead, they are a tool to be used for both income and capital appreciation when bullish phases warrant their application. I am a big fan of all three of the aforementioned funds, because they have yielded excellent outcomes under the favorable circumstances we have experienced over the last several years.

Since the 2011 bottom, DVY and SDY have gained more than 75% in total return, while VIG has jumped over 69%. In addition, all three of these dividend ETFs are offering competitive income streams well in excess of the meager 1.79% yield on SPY.

However, if risk management is your number one priority, you may need to consider other alternatives during the next corrective phase. This is particularly important with the market near all-time highs and having gone several years without testing its long-term moving average.

The summer months often precipitate additional volatility that can lead to swift drawdowns in a very short period of time, similar to what we experienced in 2011.

Risk Management Plays For The Next Correction

The first step I always recommend is for investors to place a trailing stop loss or other sell discipline on their holdings to guard against a protracted downtrend. That way, you can sleep well at night knowing you have a defined exit point for your capital that will always backstop your investment thesis.

There are also a variety of other defensive measures you can take to lower the volatility of your portfolio. This may include adjusting your asset allocation to embrace greater exposure to fixed income or cash, in the event that your stop losses get hit. A mix of treasury and investment-grade corporate bonds in the Vanguard Intermediate-Term Bond ETF (NYSEARCA:BIV) could surge significantly on a flight to quality that sends interest rates lower. This ETF has gained 5.10% so far in 2014, on the back of a drop in the 10-Year CBOE Interest Rate Note Index.

Another strategy might entail adding sector-specific themes such as the Consumer Staples Select Sector SPDR ETF (NYSEARCA:XLP). This large-cap ETF invests in a variety of consumer goods companies that produce essential products with inelastic demand. Under both time frames that were tested above, XLP produced considerably less drawdown than the broader market.

In addition, there are several ETFs that offer low volatility strategies, such as the iShares MSCI USA Minimum Volatility ETF (NYSEARCA:USMV). This fund selects a group of stocks from a diversified index with lower average price fluctuations than their peers. That may translate to a more muted decline that helps minimize peaks and valleys from erratic price swings.

The Bottom Line

In order to discern logic from an irrational market, it's easy to assume that the next correction will be similar to prior events. However, I would not bet on a future dip taking a parallel path. There will always be a twist that makes each episode unique and will require flexibility to navigate unscathed. Having a disciplined investment approach that incorporates active changes will play a key role in a successful outcome for your portfolio.

Disclosure: The author is long USMV, DVY. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: David Fabian, FMD Capital Management, and/or clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities.