SDY: Continuing To Lag

Summary

• SDY has lagged the S&P 500 and other dividend funds since 2018 began.
• While SDY's dividend growth has been impressive, it is not enough to make up for a smaller total return.
• I'm not impressed with SDY's top holdings, and don't believe it is the best make-up for a growing economy.

Main Thesis

The purpose of this article is to articulate why I believe the SPDR Dividend ETF (NYSEARCA:NYSEARCA:SDY) is not an attractive investment option at its current market price. SDY has been moving higher over the past year, but its overall return has lagged both the broader market and other dividend growth funds. Some of the fund's top sectors, such as consumer staples and utilities, are not ideal holdings for a growing economy, which we are currently in. Furthermore, while it has a lot of financial exposure, it lacks some of the big banks (which I currently favor) such as JP Morgan Chase (JPM) and Bank of America (BAC) because of their dividend cuts, even though the stocks are performing very strongly and have greatly increased their dividends in the short-term. Finally, with interest rates moving higher in 2018, SDY's yield simply may not be enough to attract investors in the short-term.

Bottom-line

First, a little about SDY. The fund's objective is to match the returns and characteristics of the S&P High Yield Dividend Aristocrats Index. This index screens for companies that have also followed a policy of consistently increasing dividends every year for at least 20 consecutive years. The fund currently sits at $91.35 and has a SEC yield of 2.39%, according to State Street. During my last review of SDY back in January, I recommended investors avoid the fund. Since that time, SDY is down about 4%. Furthermore, the fund has under-performed both the broader S&P 500 and similar dividend ETFs, such as the Dividend Appreciation ETF (NYSEARCA:VIG), since the start of the year. While this has undoubtedly given SDY a more attractive valuation, I believe SDY will continue to lag both the market and other dividend funds, and I will explain why in detail below.

Top Holdings - Lukewarm Feelings

One of my primary concerns when I reviewed SDY to start the year, was my outlook for the some of the fund's top holdings. They were companies I was not overly excited about, and did not expect to perform well in 2018. For this review, I will consider the top five holdings, the top two of which are the same as in January. Of course, SDY has over 100 holdings, so even if the top stocks do not perform well, the fund could still have a great year. However, due to the fact the top five stocks make up around 9% of the total fund, it is important to consider how well they will perform, since under-performance could be a drag on the fund.

Stock	YTD Share Price Return	Most Recent Dividend Growth	My Outlook
AT&T Inc. (T)	(8.8%)	2.0%	Neutral
Tanger Factory Outlet Centers Inc. (SKT)	(13.7%)	2.1%	Negative
Realty Income Corporation (O)	(10.5%)	0.5%	Neutral
National Retail Properties Inc. (NNN)	(11.4%)	4.4%	Neutral
International Business Machines Corporation (IBM)	2.5%	7.1%	Positive

Click to enlarge

Source: Yahoo Finance

As you can see, in terms of share price appreciation and dividend growth, this is not a line-up to be especially proud of. Couple this with the headwinds I see in the telecommunications and real estate sectors, and I have to conclude my outlook for these sectors is not rosy for the rest of the year, even with the correction they have seen.

Put simply, in my view, these drops are entirely justified. Taking them one at a time, I see T facing increased competition, both short-term and long-term, which will weigh on the company's ability to raise prices and will pressure margins. With respect to SKT, my outlook for retail is increasingly negative. While incomes are rising broadly and consumer spending is still showing positive improvement month-to month, the gains are slowing. Furthermore, while online retail sales amount for an estimated 10% of total sales, this figure is expected to continue to grow over time, which is not a positive development for traditional outlet centers. For O and NNN, the real estate sector is another area I am neutral on. I do see some bright spots here, as last year's tax reform included favorable treatment for some real estate businesses, and a growing economy could push up both the value of properties and the amount of rent commercial property owners can charge. However, increasing interest rates will undoubtedly pressure the real estate market, both residential and commercial, and represents a very real headwind for the sector not just this year, but for the foreseeable future. Finally, IBM is the one firm I actually have a positive view on, as I am bullish on the information technology sector as a whole and, of course, IBM is one of the top firms in the business. Furthermore, according to Gartner consultancy, information technology spending is expected to rise roughly 4.5% this year, compared to last year, and this growth is expected to occur worldwide, not just in the United States. This should drive demand for some of the services IBM provides, and makes me optimistic about the firm's long-term outlook.

Dividend Growth Comparison

While the top holdings of a fund are important, an equally important trait is whether or not the fund is fulfilling its basic investment strategy. In the case of SDY, this means holding dividend payers that grow their dividend every year. To see how SDY has stacked up to this objective recently, I will compare its dividend growth to other funds. In addition to VIG, which I mentioned earlier, I will compare it to the popular iShares Core Dividend Growth ETF (NYSEARCA:DGRO), as well as the SPDR S&P 500 ETF (NYSEARCA:SPY).

Fund	YOY Dividend Growth	1 Year Share Price Return
SDY	25.3%	5.1%
VIG	(6.6%)	13.9%
DGRO	19.5%	13.8%
SPY	6.2%	14.4%

Click to enlarge

Source: Yahoo Finance

The bright side of this chart is it shows SDY is fulfilling its basic function, to deliver a rising dividend year over year. In this case, it was quite a substantial increase, and bested other dividend growth funds, as well as the market as a whole. This tells me SDY is giving investors what they paid for in a basic sense, and has done a better job, at least in the short-term, than other investment strategies. The bad news is, the fund still lags in terms of overall return. While its dividend growth has a high percentage gain, its actually yield is still quite low, telling me the share price may have gotten a bit ahead of itself. Furthermore, its total return is noticeably behind the market and other popular dividend ETFs, which makes me question if SDY really is the best investment choice at this time.

Interest Rates - A Headwind

Another important consideration for SDY is the outlook for interest rates. Of course, this is not a unique risk for SDY in isolation, the entire market is reacting to Federal Reserve action, but dividend funds, which can act as bond proxies, are especially sensitive to any rate movements. The good news is, rates are still low be historic standards. Therefore, even if the Fed does raise rates this year, and next year, interest rates will still be below what they were before the recession occurred, as displayed by the chart below:

Source: BBC

That said, increasing rates will surely apply pressure to dividend funds like SDY. And the reality is, rates are likely heading higher, and possibly at a faster rate than many had originally anticipated. According to the minutes from the Fed's March meeting, which were just released this week, the majority agreed that a gradual approach to raising interest rates remained appropriate for now, but some participants "expect stronger growth and inflation in the next few years" and suggested the path for interest rates "would likely be slightly steeper than they had previously expected". While the message is still mixed, it seems clear the Fed is considering becoming more hawkish. The real question is when. Some investors are taking this to mean we could see four rate hikes this year, instead of the projected three. However, this sentiment is not yet priced in, and is still the minority opinion. According to CME Group, which tracks the futures market for investor sentiment on interest rate movements, the probability of seeing four (or more) increases by the end of the December meeting stands at just above 39%, as seen by the chart below:

Source: CME Group

The two important takeaways from this are: 1) The majority of investors still expect to end 2018 with three (or fewer) interest rate hikes. 2) The chances of a fourth hike are up noticeably, by about 6% since last month. Therefore, expectations of a more aggressive Fed, while not the majority opinion, are growing, and that could cause some future pain for SDY.

Bottom-line

SDY has been a crowd favorite before and during the recession, as investors hunted for quality dividends. To date, SDY continues to meet its core investment objective, delivering a growing dividend, and at a rate faster than many other funds. The bad news is, SDY's total return has lagged, which was my concern to start the new year, and continues to be my concern as we start Q2. It's top holdings are not attractive, in my view, delivering negative returns and unimpressive dividend growth, which are a drag on the fund as a whole. Until SDY is able to shed these non-performers, I remain neutral on the fund as a whole. As my outlook for the majority of its top stocks is negative, I don't see a turnaround any time soon, and expect future pressure on dividend funds as the Fed eyes a more aggressive policy stance. Therefore, I continue to remain unimpressed with SDY for 2018, and would recommend investors avoid initiating new positions in the fund at this time.

Analyst’s Disclosure: I am/we are long SPY. 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.