The Case For Owning Isolated Dividends

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Includes: DVY, IDIV, SDY, SPY, TIPS, VIG
by: Ariel Santos-Alborna

Summary

IDIV is an ETF that separates S&P dividend cash flows from S&P price action.

It offers a high Sharpe ratio, low correlation to other asset classes, and a pure play on expected inflation.

Investors should consider this fund as a diversification tool for their portfolio.

Though new in its conception, the IDIV ETF is one of the more interesting financial innovation products on the market. By separating dividends from S&P 500 price action, it provides investors access to dividend cash flows without facing direct equity risk. This article explores how isolated dividends work and why investors should consider adding this asset to their portfolio as a tool for diversification.

How It Works

Like most lay investors, I am a skeptic when it comes to certain types of financial innovation. Take the second-order effects of mortgage backed securities. Once a money-making machine for banks and hedge funds, MBS created systemic risk by increasing demand for underlying mortgages and reducing lending standards. However, some forms of financial innovation are relatively straightforward. Isolated dividends work in the same manner as Treasury Inflation-Protected Securities (OTC:TIPS). Returns on TIPS are based on changes in published CPI. If inflation remains unchanged, a TIPS investor’s yield will equal the yield of a U.S. treasury of comparable maturity. If inflation is higher or lower than the market’s expectations at the time of purchase, the yield will be higher or lower than the comparable U.S. treasury.

Substitute the inflation independent variable with dividend growth and you have a basic understanding of how isolated dividends work. Isolated dividend funds such as IDIV are comprised of U.S. Treasury securities, cash, and a collection of S&P dividend futures contracts. An investor’s return depends on the difference between the dividend actually paid on the S&P 500 Index and the price of the dividend future at the time of the initial investment. If actual dividends end up being greater than the forecasted dividend future, an investor will receive a return above a comparable duration treasury and vice versa. Much like TIPS, a higher deviation will lead to a higher return or loss. If investors believe dividend growth will be higher than expected, owning isolated dividends makes sense. The chart below compares future dividend expectations until 2027 with the historic annual dividend growth rate. From a value perspective, because dividend expectations are below the historical growth rate by over 2%, owning isolated dividends has a significant margin of safety.

dividend growth rate (Source: Dividends: The New Asset Class)

Analyzing the Risk/Return Profile

The main attraction of owning isolated dividends stems from its potential as a portfolio diversifier. IDIV exhibits a greater Sharpe ratio than the S&P 500 (SPY), a low correlation to other traditional asset classes, a positive correlation to rising interest rates, and a positive correlation to inflation.

Changes in dividend growth have been positive in 42 of the last 45 years, with S&P dividend growth being less volatile than S&P price action. The Sharpe ratio, a measure of risk-adjusted returns, is calculated by taking the average return of an asset, subtracting the risk free rate, and dividing by unit of volatility (beta). Examining the period of 1973-2017, isolated dividends have returned 6.35% to the S&P’s 10.28%. However, it attained this with a standard deviation of 6.22% compared to the S&P’s 17.26%. In fact, dividend growth taken in isolation exhibits the highest Sharpe ratio of nearly any asset class in the past forty years, including 10-year treasury prices. The characteristics of 6% growth and subdued volatility make it a potential alternative to fixed income.

(Source: Ibid.)

(Source: Ibid.)

Additionally, IDIV contains a relatively low correlation to traditional asset class as indicated below. For reasons discussed in the next section, dividends actually have a greater correlation to CPI than the S&P 500. In terms of its correlation to the S&P, companies only tend to reduce dividends as a measure of last resort. Dividend cuts can shake investor confidence and trigger massive sell-offs, making companies wait out periods of underperformance as opposed to signaling poor future returns with a dividend cut. Actual price action of the index has decreased in 9 of the last 45 years while dividends have only decreased in 3 of those 45.

(Source: Ibid.)

Lastly, dividends have fared well in a rising rate environment. Overheating economic conditions usually trigger rate hikes, and rate hikes tempt to occur in response to inflation—which as previously mentioned correlates positively with dividends. While interest rate hikes may threaten the dividends of highly-leveraged industries such utilities (as higher rates lead to higher debt service payments), they tend improve the margins of financials and have no effect on industries with pricing power, creating a wash in terms of dividend winners and losers in a rising rate environment. In fact, since rate hikes began in September of last year, dividends have increased by 2.22% while bond prices have fallen, thus further legitimizing dividends as a diversification play.

Alternative to TIPS

TIPS is a novel concept with a major flaw: the U.S. government is incentivized to under-report inflation. The higher the reported CPI, the more the government needs to spend on cost of living adjustments for social security, food stamps, pension systems, etc. Under-reporting inflation numbers makes government deficits manageable. Before being accused of perpetuating conspiracy theories, allow me to run through the numbers.

CPI from October 2008-October 2018 has gone from 218.78 to 252.43. This constitutes a 15.4% total increase and a 1.44% increase compounded annually. Meanwhile, the Pricewaterhouse Cooper Health Research Institute has calculated healthcare inflation at roughly 6.8% compounded per year during the same time span. Healthcare accounts for 18% of U.S. GDP. Therefore, (18% X 6.8% =) 1.22% of total compounded inflation is attributable to healthcare inflation, yet CPI reports 1.44% total inflation. If CPI were accurate, the rest (82%) of the U.S. economy had an average annual inflation rate 0.22% for the past ten years. Another way to expose the systematic under-reporting of inflation is through tracking the actual cost of something compared to the CPI reported cost. The Big Mac Index was created as a tool for economists to measure purchasing power parity between countries’ currencies. A Seeking Alpha article here uses this tool to track the actual price versus CPI reported price. As the second chart below indicates, a McDonalds Big Mac today would cost $2.43 if inflated according to CPI numbers. In actuality, a Big Mac in the U.S. costs $5.51.

(Source: PwC Medical Cost Trend)

(Source: The Big Mac Index may be Telling the Truth About Inflation)

Inflation does not show in CPI because entitlement spending would be unmanageable otherwise. It does, however, show in company earnings and dividends. TIPS, with returns bound to expectations in CPI, is systematically low. Company dividends, which do not contain the risk of government manipulation, more accurately reflect true inflation numbers. For this reason, IDIV is a better play on future expected inflation than TIPS and should be considered as an alternative.

Conclusion

Dividends as an investable asset is an exciting opportunity for investors due to the diversification it provides. While many investors will view the securitization of equity markets with skepticism, isolated dividends work in a fairly straightforward manner. They increase and decrease in accordance with the difference between S&P dividends paid and S&P futures contracts. Due to potentially underpriced dividend futures contracts, a high Sharpe ratio, and a positive correlation to inflation and interest rates, IDIV may be a safer asset to own during volatile times.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in IDIV over the next 72 hours.

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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