DVY Continues To Be A Winner

| About: iShares Select (DVY)

Summary

Rates have remained stubbornly low, benefiting dividend funds.

DVY's low beta and above average yield will help ride out any market volatility.

If rate hikes are delayed, DVY will outperform the market.

The purpose of this article is to determine the attractiveness of the iShares Select Dividend ETF (NYSEARCA:DVY) as an investment option. To do so, I will review DVY's recent performance, current holdings and sector weightings, and trends in the market to attempt to determine where DVY may be headed for the rest of 2017 and beyond.

First, a little about DVY. The fund seeks to track the investment results of an index composed of relatively high dividend paying U.S. equities. The index includes companies with comparably high dividend yields that have at least a five year track record of paying those dividends. DVY is currently trading at $91.43/share and its two most recent dividend payments have been for $.70/share. If that continues, the fund will return an annual yield of 3.06%. Year to date, DVY has underperformed the market, with a return close to 4%, inclusive of its dividend payment while the Dow Jones, a popular benchmark, has seen a return just under 6%. However, DVY is not designed to track the DOW, but rather to provide investors with reliable income through its above average yield. When comparing DVY to similar funds, there is a slight outperformance. Two extremely popular dividend funds, VYM and SDY, have returned 2.3% and 3% while yielding 2.9% and 2.0%, respectfully, based on their current market share price and most recent dividend payment. Therefore, when compared to its peers, DVY has been a solid investment so far this year and there are a few reasons that I believe this performance will continue.

One, interest rates are staying near historic lows for longer than anticipated, as the Fed has increased rates in a very slow, organized manner. These small hikes have allowed dividend funds to continue to prosper, even as rates edge up. The primary reason for this being rates are still at historic lows, so investors have not completely abandoned dividend funds, which makes sense. Two year and five year U.S. government bonds are yielding 1.30 and 1.82%, respectfully. Investors are not going to completely abandon dividend funds paying in excess of 3% for those returns, especially given the fact that dividend payouts have been increasing at many major U.S. companies. As long as cash-rich companies continue to reward their investors with higher dividend payouts, yields in major dividend ETFs will rise along with bond yields. However, this does highlight why it is essential to choose the right dividend fund in a rising rate environment, as rising bond yields do present a risk. But DVY fits this bill, because the fund is comprised of not only high-yielding stocks, but companies with a consistent track record of paying those dividends. When investors are confident that a fund will continue to maintain or increase its yield, they will be less likely to flee the fund for alternatives.

Two, I believe DVY's sector allocation will allow DVY to continue to outperform, especially as market uncertainty begins to creep in. While the market rallied strongly following President Trump's election victory, uncertainty has begun to rise as investors are starting to question whether all his pro-market campaign promises will come to fruition. As Trump begins to face the political realities of Washington D.C., I expect we will see periodic bumps throughout the rest of the year. DVY's heavy reliance on the utilities sector will allow investors to ride out any turbulence with ease. The utilities sector makes up almost 30% of the fund's portfolio, and is a sector known for reliable revenue streams. This exposure is a key reason why DVY's yield is higher than many other dividend funds, and also why it sports a beta of .67, indicating the fund is less volatile than the market as a whole. To put this in perspective, the funds I mentioned earlier (VYM and SDY) have betas of .83 and .81, respectfully. This indicates to me that DVY is better poised to ride out market volatility, all while paying a higher yield.

In addition, DVY's financial sector exposure clocks in at 13.45%, making it the third largest sector of its portfolio. I believe this is an attractive trait because it provides DVY with a nice hedge against rising rates as they occur. This is especially important since the utility sector could be a drag on the fund if rates rise too quickly. The financial exposure will help offset that scenario because financial firms benefit from a rising rate environment. The logic follows that as the economy improves and rates rise, banks and other financial firms increase the rate they charge for loans and services at a quicker pace than what they pay out for deposits; increasing their interest rate spread and profitability. An added benefit is, with a strengthening economy, the percentage of loans that go in default will decrease, also positively impacting profitability.

Three, I prefer DVY because of its biggest holding, Lockheed Martin Corporation (NYSE:LMT). LMT makes up almost 4% of DVY's portfolio and its stock has soared on the announcement of the US - Saudi Arabia arms deal announced on Monday. The deal will be worth $350 billion over 10 years and LMT is a primary beneficiary. LMT is up 2.5% this week, almost 12% year to date, and stands to move even higher throughout 2017. If history is used as a guide, one month after about 40 U.S.-Saudi Arabia arms deals - going back to 2009 - the iShares U.S. Aerospace & Defense ETF was up 3.3 percent, on average, almost double the return of the S&P 500, according to data compiled by Kensho. Being DVY's largest holding, what bodes well for LMT bodes well for DVY, and the next few months seem destined to be positive.

Of course, investing in DVY is not without risk. The chief risk for the fund has to be interest rates, especially given DVY's heavy exposure to the utilities sector. Rates are increasing, and the market expects them to continue to increase, which could send investors away from the dividend funds that they have flocked to over the past 8 years. If the Fed raises rates at a quicker rate than expected, investors could rotate into bond funds and away from dividend funds, hurting DVY. However, I do not see this scenario occurring, as dividend funds still provide a yield much higher than Treasuries, and with companies continuously upping their dividend payouts, these funds will remain competitive even as bond yields rise. Furthermore, while investors seem all but certain of a rate hike in June, the outlook beyond that remains mixed. For instance, Fed funds futures, used by investors to place bets on the Fed's interest-rate policy, on May 8th showed an 83% chance that the Fed will tighten policy at its June meeting, according to CME Group. That was up from 68% one week ago. However, the chances of at least one more interest rate increase by the Fed's December meeting were put at just 57%. Earlier in the year investors had anticipated three rate hikes, so the possibility of only two should be a positive catalyst for dividend funds.

Bottomline: DVY has lagged the broader market so far in 2017, yet outperformed competing dividend funds. With an above average yield and low beta, the fund is poised to perform well in times of uncertainty. It remains one of the few dividend funds that can provide investors with income at a rate higher than 3%. With a clouded political outlook in the U.S., as well as uncertainty regarding the Fed's rate hike intentions for the rest of the year, I would encourage investors to take a serious look at DVY as we head in to 2018.

Disclosure: I am/we are long DVY.

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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