Dividend Investors Should Consider A Dose Of 'Reality'

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Includes: DFND, DIVY, FB, GARD, GOOG, GOOGL, LEAD, O, PG
by: Adam Aloisi

Summary

Reality Shares is a boutique firm focused in on dividend strategies.

All four of its funds have operating platforms unlike most run-of-the-mill dividend ETFs.

Profiles and commentary on all four, following a phone interview I conducted with President and CEO Eric Ervin.

I recently had the opportunity to speak with Eric Ervin, President and CEO of San Diego based Reality Shares, a boutique firm boasting a line-up of four fairly-new-to-market ETFs focused on dividend strategies. Namely:

  • Reality Shares DIVS ETF (NYSEARCA:DIVY)
  • Reality Shares DIVCON Leaders Dividend ETF (BATS:LEAD)
  • Reality Shares DIVCON Dividend Defender ETF (BATS:DFND)
  • Reality Shares DIVCON Dividend Guard ETF (BATS:GARD)

The firm has won numerous awards owing to its efforts, including DIVY being named "Most Innovative ETF - Americas" at this year's 12th annual Global ETF Awards.

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Reality Shares President & CEO Eric Ervin

Unlike some of the mundane dividend and dividend-growth ETFs that seem to mimic or largely resemble large-cap weighted indices, Reality's funds include proprietary strategy (DIVCON), short selling, and in one of the four, market timing. Its most unique dividend fund, DIVY, doesn't pay a dividend or invest in dividend stocks at all. Yes, you heard that correct.

In this article, we'll take a look at all four strategies and consider whether any possess particular merit for dividend investors.

It's all About The DIVY

DIVY is designed to track the dividend growth rate of the S&P 500 Index without any associated price risk. The fund invests in S&P 500 dividend swaps through various counterparties, but with virtually no counterparty risk.

Since it does not pay a dividend, DIVY would not serve as a core position for a cash-capture dividend growth investor, but could serve well as a portfolio hedge or an alternative strategy. Minus fees, the fund attempts to provide an annual return symmetric to YOY S&P 500 dividend growth. Over the past several decades, that return has averaged about 6.5%, compounded.

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Risk is difficult to quantify, but seems to sit somewhere between dividend equity and fixed-income. The investor is somewhat exposed to the volatility of the macroeconomy, director dividend subjectivity, as well as YOY dividend decline, but bears no price risk -- but no contractual capital guarantee either.

The strategy might work particularly well if conviction exists that sees stocks headed towards another "Lost Decade" similar to that following the burst of the Y2K Internet bubble. In that kind of scenario, stock prices head largely lower as hefty multiples are burned off, all the while corporations collectively continue to boost bottom lines and raise dividends.

Since inception and as of 10/19, DIVY has returned about 5.2 percent in total. Unfortunately, the fund's 85 basis point expense charge materially impacts expected rate of return here. If we assume an average return at the implied 6.5%, the current fee eats away 13% of that potential right off the bat, down to an implied 5.65 percent.

Going forward, my personal inclination is that dividend growth rates may start to cool a bit relative to what we've seen since the financial crisis. My readers know that I've been cautious, especially on mega-cap blue-chips with rising payout ratios, and prefer a somewhat off the beaten path mentality to maximize income growth potential and total return.

In my discussion with Ervin, he presented a somewhat different take, arguing, via his analytics, that collective dividend health in the S&P 500 is better now than it has been over the past 15 years. He pointed out that while payouts as a percentage of earnings have indeed been rising, that payouts as a percentage of free cash flow, have actually been declining -- paving the way for improving forward dividend growth.

He also points out that cash cow S&P 500 companies like Facebook (NASDAQ:FB) and Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL), which don't currently pay a dividend, but might soon, will provide further trajectory to dividend growth. More generally, he says that cash positions are healthy amongst the large-cap group.

Playing devil's advocate, one could conclude with the earnings/FCF differential that companies are hunkering down, raising cash and not reinvesting in themselves in anticipation of a global slowdown, black swan event, or worse. Thus rising free cash could actually be a lagging indicator of dividend health and a leading indicator of a growth slowdown in the years ahead.

Taking The LEAD

Reality Shares DIVCON Leaders Dividend ETF is the firm's foundational long-only fund that utilizes a 7-factor proprietary ratings system (DIVCON) to identify companies with the strongest forward dividend growth potential. Those with the strongest ratings are given a "5", while the weakest are given a "1".

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In terms of LEAD, it's charter requires it to hold at least 30 stocks, with no particular yield requirement. Presumably, if the dividend environment were to collectively improve, the fund would hold more stocks. If the environment were to deteriorate, the fund would be unable to concentrate lower than 30 positions, even if they rated lower in the system.

So when you peruse its top 10 holdings, you'll notice two things. First, a relative absence of mega-cap names, and second, an absence of higher yielding names. To point, one of the companies has a yield firmly above 3 percent.

Source: Ameritrade

I talked to Ervin about this and queried whether the fund should be looked at as more of a total return maximizer as opposed to anything else. He concurred with that characterization.

In terms of performance, we have a short track record to go on since the fund only started trading in January. LEAD, including 27 cents of dividend payments this year, has returned roughly 4.35 percent since inception. Over the same time frame, its comparative benchmark, SPY, has returned double that, 9.7 percent.

However, in a backtest conducted by Reality Shares from 1/1/2001-12/31/2015, LEAD materially outperformed SPY.

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LEAD's expense ratio at 43 basis points, is certainly not as cheap as a Vanguard or iShares total index, but probably reasonable for a smart beta portfolio of this nature.

While it's not exactly off to a good publicly traded start, I'd opine that LEAD's strategy would serve as a solid diversifying agent to the garden variety higher-yielding dividend growth portfolio consisting of usual suspects such as Realty Income (NYSE:O), Procter & Gamble (NYSE:PG), and the like. Again, however, for the dividend capture purist, LEAD with a likely 12-month dividend run yield settling somewhere between 1.5-1.75%, would probably not be high on the list of core options.

Still, for someone in need of a bit more total return potential, but looking for a portfolio of dividend stocks with high quality, durable attributes, I'd see LEAD on a potential short list of considerations.

On GARD & DFND

Reality Shares' other two funds include both the long exposure of LEAD as well as a short component. In the case of DFND, the short exposure is perpetual. In the case of GARD, the exposure will be intermittent.

Reality Shares DIVCON Dividend Defender ETF, ticker DFND, seeks 75%/25% long/short exposure at all times. In addition to the 75% long component as dictated by LEAD holdings, 10 stocks with the lowest DIVCON ratings represent the remaining quarter of the portfolio. When we examine DFND's top 10 holdings, we see the long overlap with LEAD as well as four short positions within the red box.

Source: Ameritrade

The short DFND component is also allocated/reconstituted once a year in December and is limited to ten total positions.

Going one step further, Reality Shares DIVCON Dividend Guard ETF, ticker GARD, includes a market strength system that can cause the fund to swing to a 50/50 long/short position from all-long if and when conditions dictate. In our discussion, Mr. Ervin told me that the Guard Indicator was bearish from September of 2015 until May of 2016. So when the fund launched in January (2016), it maintained a 50/50 long/short position. Today, with the indicator back to a bullish stance the fund sits with a 100% long portfolio.

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If and when GARD next goes to a short position, it would mimic the same positions as DFND. There is no middle ground with GARD -- either all long and reflective of LEAD or 50/50 long/short.

In terms of performance, both DFND and GARD, like LEAD, initiated operations earlier in January. DFND is down 2.35% since inception and GARD is down a whopping 13%, due probably mostly to its short position between February and May as the market recovered from the early year sell off.

Despite this year's slow start, backtests conducted over the 1/1/2001-12/31/2015 timeframe indicate mild total return outperformance from DFND compared to SPY, and meaningful outperformance (>3X) from GARD. The light blue shaded regions in the graph below indicate times of an implied 50/50 long/short position as dictated by the Guard Indicator.

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Another fundamental consideration for those looking at DFND or GARD would be the fact that short positions, in addition to the unlimited price risk they entail, require that borrowers pony up the periodic dividend payments to a counterparty. Hypothetically, if a short position remains static in terms of price, you'd still lose whatever dividend payments must be made over the time frame you hold the short.

Despite the inherent risks of shorting stocks, there would seem merit in both DFND and GARD to the extent there is reason to hedge a solely long market position. DFND's static 25% short component would seem to be the much safer play and potentially an alpha-rich play assuming the system's DIVCON level "1" identifications prove accurate both in up and down markets.

GARD, given its dynamic timing mechanism, would be a far riskier, but potentially alpha-rich long-term play. As we've seen already this year, however, timing miscues can negatively impact near-term performance. The 20% plus performance spread between GARD and SPY this year alone is implicative of that.

On the other hand, if Ervin's Guard Indicator proves more accurate than faulty in terms of timing, as the backtest suggests, then this could be a serious winner in coming years.

Cost of entry here is not cheap with roughly a 1% expense ratio for both GARD and DFND. However, especially in the case of GARD, a few accurate timing calls would make that money well spent.

Conclusions

Amidst the ever increasing pile of dividend-oriented ETFs, Reality Shares' four offerings provide a variety of strategic vision and risk exposure for what I would consider a large group of dividend/total return investor types. Though I'm not sure I'd characterize any of the four as a table-pounding buy opportunity at the moment, DIVY, as the most unique of the Reality Shares bunch, offers wide alternative appeal in this era of elevated equity-income valuations.

LEAD could serve as a core ETF position for the total return minded dividend investor or as a diversifying element in a primarily mega-cap portfolio. Still, given today's generally elevated valuations, I'd tippie-toe rather than dive right into what may prove to be a rather shallow near-term pool.

DFND, as I noted above, probably has some merit for the valuation-squeamish or those otherwise looking for a hedge. However, I have general reluctance in extolling the virtue of a static 25% short position in dividend-paying stocks. The near-1% fee also gives me reason for pause there.

You'd have to have a pretty thick stomach to load up on GARD, and I certainly wouldn't recommend it in good conscience to anyone with a conservative risk tolerance. Although if Ervin's indicator is able to forward game the market as successfully as his backtest might indicate, this might turn out to be a grand slam aggressive growth/total return play for those with time (and risk tolerance) to see the Guard Indicator play out over time.

Disclosure: I am/we are long FDN.

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.

Additional disclosure: Disclaimer: The above should not be considered or construed as individualized or specific investment advice. Do your own research and consult a professional, if necessary, before making investment decisions.