After all, you only find out who is swimming naked when the tide goes out. - Warren Buffett (Berkshire Hathaway letter 2002)
In a low volatility bull market, it is difficult to separate one ETF from another based on performance. A certain fund might be a strong performer simply due to assuming additional risk. Only when the markets are in trouble, do you spot that the fund was skinny dipping.
This is one of the reasons why I encourage looking carefully into the methodology of each ETF and the construction rules instead of just monitoring a group of ETFs for a few years and picking among the highest performers with the lowest expense ratio. That can be a recipe for trouble.
Below is a chart comparing the year-to-date performance of various high dividend ETFs.
- AAM S&P 500 Sector High Dividend ETF (SPDV)
- ALPS Sector Dividend Dogs ETF (SDOG)
- Vanguard High Dividend Yield ETF (VYM)
- iShares Select Dividend ETF (DVY)
- SPDR Dividend ETF (SDY)
- Schwab U.S. Dividend Equity ETF (SCHD)
To be perfectly honest, a snapshot of a few months of price performance is not enough history to make any conclusive remarks. Still, it is of interest. Looking into the methodologies, what might be some of the risks not readily apparent?
Funds which are cap-weighted weight towards the most expensive stocks. If you want the largest company or firm, you should use fundamentally weighted funds. If you assume that prices are noisy and revert to their true values over time, then a cap-weighted scheme could harm returns.
- 2 stocks have the same fundamental value of $10. You do not know this at the time.
- One stock is trading at $8 and the other at $12.
- If they revert to their fundamental value, the equal-weight investor will earn an excess return of more than 4% as opposed to the cap-weighted investor in these 2 stocks.
Vanguard High Dividend Yield ETF and Schwab U.S. Dividend Equity ETF are cap-weighted. You can read more on this topic in the white paper, Cap-Weighted Portfolios are Sub-Optimal Portfolios.
Too Heavily Tilted Towards Large Yields
When it comes to dividend yields, more is not always better. The highest yielding products might be priced that way due to risk. While I like moderate yields, focusing on the highest yielding securities could increase downside risk during market turbulence. A fund might focus on high dividends in two separate ways:
- Stock picking methodology
- Weighting scheme
Take the ALPS Sector Dividend Dogs ETF as an example. While all positions are held equal-weight, the stock-picking methodology is to include up to 5 of the highest yielding S&P 500 stocks per sector. This might be assuming additional risk. Vanguard High Dividend Yield ETF also has a high-yield stock-picking methodology.
Another consideration would be related to weighting toward each sector.
- DVY is 30% weighted towards utilities and less than 6% weighting towards information technology
- SCHD has less than 1% weighting towards utilities and almost 20% towards information technology
If the utilities or the information technology sectors should drop, these two funds would suffer due to the heavy sector weighting.
Of the above-listed ETFs, my preference is for the AAM S&P 500 Sector High Dividend ETF. You can read about my reasons for liking it here which include the factoring in of free cash flow yield, sector balancing, and equal-weighting of positions. It is also the top performer of these ETFs year to date. It is a new ETF but one with a lot of promise.
I will be monitoring these ETFs closely as volatility will help us see which of these high-dividend ETFs forgot their swimming trunks over the next few months.
Note: I forewent my writing compensation on this article as it deviates from my normal in-depth look into ETF methodologies and investment practices. Yet, I still wanted to convey what was on my mind today.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.