Choosing Between Dividend ETFs DVY and PEY Based on Future Expected Returns

by: XTF Advisors

In the aftermath of the stock market bubble, says XTF Advisors, many investors are waking up to the fact that dividends are an exceptionally important piece of the investment puzzle. The dividend tax cut passed by Congress in 2003 along with a graying investor class (naturally more interested in income and stability) making it likely that the renewed interest in dividends is more than a passing fad.

Two recently listed ETFs provide an easy way to invest in a diversified portfolio of dividend paying stocks:

PowerShares High Yield Equity Dividend Achievers PortfolioTM (NASDAQ:PEY) tracks the Dividend Achievers 50 Index published by Mergent.
iShares Dow Jones Select Dividend Index Fund (NYSEARCA:DVY) tracks the Select Dividend Index published by Dow Jones.

Although the funds themselves are relatively new, the indices they track have been published for more than a decade, and have produced returns that substantially exceed those of the S&P 500.

Both indices had nearly identical returns (reinvesting dividends, but ignoring taxes and transaction costs) over the past ten years, from May 31, 1995 through May 31, 2005, with the Mergent Dividend Achievers 50 Index gaining 429% (15.7% annualized) compared with a 428% gain (15.7% annualized) for the Dow Jones Select Dividend Index—far superior to the S&P 500’s 264% gain (10.2% annualized).

While these dividend-oriented strategies actually lagged the S&P 500 for a number of years during the bubble of the late 1990’s when ‘stodgy’ dividend paying stocks were virtually ignored, their superior performance over the long haul lends credibility to dividend-focused strategies. However, our goal here is not to convince you of the merits of dividends (of which much has been written) but rather to provide new information to help you decide which ETF is most appropriate for your portfolio. Despite the nearly identical 10-year returns of the underlying indices which these ETFs seek to track, we do not believe investors should just pick one and call it a day:

  • Historically these two indices have different characteristics, making each suitable for different types of investors
  • Recent changes in methodology behind the Dow Jones Select Dividend Index diminish the relevance of its historical performance data, making forward-looking fundamental analysis more important

But before trying to divine where these portfolios are headed, we’ll analyze where they’ve been. Historically, the Dividend Achievers 50 has derived a greater portion of its total return from dividends, while the DJ Select Dividend Index has been more dependent upon capital gains. This had the effect of reducing volatility for the Dividend Achievers 50, which combined with the fact that the two indices had nearly identical returns over the past ten years resulted in superior risk-adjusted returns for the Dividend Achievers 50.

Of course, past performance is no guarantee of future results. This maxim is particularly true is this case, because the Dow Jones Select Dividend Index which DVY is designed to track recently underwent major changes to methodology (such as a doubling of constituents and changes in inclusion criteria) rendering historical performance less illuminating about future potential. Fortunately, since as investors we’re ultimately interested in future returns, there are other tools at our disposal.

This is where fundamental analysis comes in. We can use consensus estimates for dividends and earnings for each constituent in an ETF, and from these we can construct a synthetic yield and growth profile for PEY and DVY. The dividend yield of each ETF based on consensus dividends per share for each constituent (weighted appropriately) over the next 12 months is:

4.0% for PEY
3.6% for DVY

and the long-term earnings potential of each ETF by using consensus estimates for 3-5 year EPS growth of each constituent (again weighted appropriately) is:

6.6% for PEY
7.7% for DVY

What does this tell us about how PEY and DVY are likely to perform in the future? It says that investors can expect to receive more dividend income from PEY (which they can use to buy more shares of PEY) than from DVY, but that companies in DVY are collectively expected to experience faster earnings growth - which in turn could support faster share price appreciation. Which helps us reach the following conclusions about each:

  • PowerShares High Yield Dividend Achievers (PEY) for yield and stability. Over the past 10 years, the Mergent Dividend Achievers 50 Index which PEY tracks, has delivered a nearly identical total return to that of the Dow Jones Select Dividend Index, but with less volatility giving it superior risk-adjusted returns. With its higher dividend yield, PEY is appropriate for more conservative, income-oriented investors.
  • iShares Dow Jones Select Dividend Index (DVY) for growth and income. DVY has a lower dividend yield than PEY but may exhibit faster earnings growth going forward, which could support faster share price appreciation. It is appropriate for more aggressive investors who are looking for capital appreciation but with the safety of some current income.
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