The First Trust Morningstar Dividend Leaders Index ETF (NYSEARCA:FDL) offers an interesting strategy for making allocations. The methodology includes a bit of a black box nature when it comes the precise allocation strategy, but the current list of top holdings demonstrates that their black box can spit out a great allocation of dividend growth champions.
The net expense ratio is .45%. The need for a higher expense ratio is understandable given the strategy in place by the ETF. The individual holdings are capped to enhance portfolio diversification, but they can become quite heavy. The index being tracked is "reconstituted once annually each June and rebalanced four times annually in March, June, September and December" according to the sponsor.
If the entire index is reconstituted each year, it creates the potential for some very dramatic turnover. The reconstitution in June lines up with the rebalancing so the investment may look dramatically different at the start and end of summer. Investors either need to buy in wholeheartedly to the strategy behind the fund or they will need to babysit their position. Since babysitting it would be a substantial pain and it wouldn't make sense to pay a .45% expense ratio for a fund that would have to be reassessed each quarter, it is important that investors here buy into the strategy.
The dividend yield is currently running 3.21%. That wouldn't seem so high if equity prices were lower and yields were higher across other investment opportunities. The current environment leaves investors starved for yield. Despite an increase in the short-term rates by the Federal Reserve in December, the longer end of the yield curve is down significantly over the last several months.
I grabbed the following chart to demonstrate the weight of the top holdings
The top holding is Exxon Mobil (NYSE:XOM) and the allocation is massive. I can't disagree, but at the same time I feel this is an exposure that investors can get with very low expense by simply buying a large position in XOM and then not touching it for the next several decades.
Moving down the chart we see that two of the highest weightings go to the telecommunications sector with AT&T (NYSE:T) and Verizon (NYSE:VZ). I've found those allocations to be fairly risky given the aggressive competition in the telecommunications industry. However, they do have a solid history of paying dividends and very respectable dividends. Since the industry is designed to include an assessment of how sustainable the dividend will be, I have to appreciate that this portfolio would be willing to remove the exposure if the analysis suggested that these giants were going to be unable to sustain their dividends.
McDonald's (NYSE:MCD) is another holding that I think should be represented in most dividend growth portfolios in one way or another. While their burgers have left a great deal to be desired over the last few years, they have still been able to remain relevant because they collected a large amount of high quality real estate. Over the last couple of quarters things began to look materially better for this real estate giant disguised as a seller of cheap burgers.
The portfolio even allocates heavily to Phillip Morris (NYSE:PM) and Altria Group (NYSE:MO). I would consider the tobacco companies to have very sustainable dividends as well. When I go through this portfolio I have to admit that they really did look for dividend champions to hold. I appreciate that, but the heavy weightings make me wonder if the individual investor can keep up with this portfolio by buying several of the holdings and sitting on the position.
Even if an investor was considering that option, they might use the holdings of this fund as a way to check for other high dividend companies that have a strong history of paying the dividend and have at least passed one screening system for dividend sustainability to avoid the risk of buying into sucker yields.
I love the sector allocation, but I can't put much emphasis on this since the rebalancing of the positions each quarter and the annual overhaul of the index means the sector exposure that I see could be substantially different next quarter and might very little in common with the sector allocation at this time next year.
Looking at this ETF means considering their strategy for allocations, and I have to admit that I do see some value here. I'm not one to quickly buy into a black box method for establishing allocations, but the top 10 holdings in the fund are demonstrating that the black box is spitting out reasonable allocations.
Normally I wouldn't refer to allocation strategies as simply being a black box, but the following image shows the description of the index provided in the "Fact Sheet":
Due to the volatility on the fund, investors would still be wise to seek further diversification, but the fund has some huge benefits as a source of domestic equity. Because the fund is committed to holding high dividend payers, their dividends should remain strong, which gives investors a way to take a material return on their investment each year without going into their portfolio and being tempted to sell off shares when the market is falling.
The system also specifically excludes REITs, which should be favorable for investors who want to hold the fund in a taxable account without worrying about the unqualified dividends coming from REITs. It also offers investors a benefit in assuring the shareholders that the fund won't be duplicating any positions that decide to establish in REITs to generate additional yield for their portfolio. The expense ratio is high for having so few companies, but I do like the strategy that is in place for investors who want to combine the fund with some equity REITs and then spend their days on the beach.
Great dividend yield and I do like the strategy in place for investors that are seeking a strong dividend yield and willing to buy into the black box technique on the strength of the holdings that were selected the last time the allocations were handled. If we were talking about a sample period of several decades, I would be worried about it underperforming the S&P 500 strictly because of the expense ratio, but I wouldn't expect it to perform poorly.
If this fund dropped the expense ratio and pushed for free trading at a few brokerages to pump up the liquidity, it would be a candidate for my lists of the top dividend ETFs.
Disclosure: I am/we are long MO, PM.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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