DIV: Income Generation, Inflation Risks And Volatility Risks

Summary

• If you're an income-oriented investor, the Global X Super Dividend U.S. ETF is appealing with its 5.5% dividend yield.
• Although under the unfolding macroeconomic conditions, the income needs to be carefully examined and adjusted for potential inflation risks.
• In addition, you also need to be aware of its volatility risks, both price volatility and dividends volatility, to be fully prepared when you rely on this fund’s income.

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The investment thesis

The Global X Super Dividend U.S. ETF (NYSEARCA:DIV) attempts to achieve three attractive traits in one income fund – high dividend yield (5.5% as of this writing), the dividend paid on a monthly basis, and low volatility.

Given its high yield nature, this article focuses on the income aspect of DIV. We will especially examine the conservation of your income’s purchasing power under the current inflation risk. You will see that DIV is an investment that can generate enough income to help fight against these risks.

However, you also will see that the fund does not deliver the low volatility it aims for. This article will analyze its volatility risks and suggests a few ideas to hedge such risks. So then you can be better prepared in turmoil times if you rely on this fund’s income.

Income generation

As can be seen from the following chart, the DIV fund indeed provided consistently high dividend income not only relative to the overall market but also relative to other dividend funds. As shown, DIV’s dividend yield started above 6% in 2013 and has stayed above or around 6% consistently since then. It's currently near 5.5%, compared to less than 1.3% from S&P 500 and about 2.8% from other comparable dividend stock funds such as the Vanguard High Dividend Yield ETF (VYM). The income aspect becomes even more attractive considering that the distribution is made on a monthly basis. Warren Buffett once made the following comments during an interview. You can see the full interview here, full of typical Buffett-style wisdom and a sense of humor. The highlights are added by me.

Yahoo Finance: how much cash should an ordinary investor have on a percentage basis?

Buffett: it depends on the personal situation…. But if I were retired and I had a say $1 million diversified portfolio stocks that were paying me $30,000 a year in dividends or something of the sort….. I would not worry too much about having a lot of cash around. And you can be more cash free than Berkshire is.

The income generated from DIV certainly has some of the traits that Buffett mentioned. The income is generated by a very well-diversified group of 50 quality businesses. And in this case, the yield is much higher than the 3% that Buffett commented - it is almost 2x as high. It is certainly an attractive fund for income investors. Now let’s move on to see the challenges.

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

DIV provides income comfortably above expected inflation

Any income generation needs to be examined under the context of inflation, and 2021 is certain a year of an inflation shock. Inflation is now a larger risk than what we (and the Fed) thought even a short while ago. So if you're an income-oriented investor, then income conservation under the inflation risks should be a high priority now.

Earlier in the year, the Fed’s narrative is that the inflation we were seeing was transitory. Then just this Tuesday, Fed Chair Jerome Powell commented that it's time to retire the word transitory from the narrative. The Fed chair also indicated the central bank could speed up the pace of cutting its monthly bond-buying. The Fed now sees inflation running to 4.2% this year above its previous estimate of 3.4%.

This is where DIV’s high current income can be really appealing for income investors. As can be seen from the next chart, currently the dividend yield of DIV is near 5.5%. First, it's higher than the expected inflation by a comfortable margin. Moreover, it also provides a wide spread above the treasury interest rates (represented by the yield on IEF from the following chart), providing a large cushion to absorb an interest rate shock. As just mentioned above, Powell also indicated the central bank could speed up the pace tapering of bond buying, which could lead to treasury bond yield to jitter. And the thick spread between DIV yield and treasury yield (more than 4%) could help cushion interest rate fluctuations.

Source: Author and Seeking Alpha data.

DIV’s own risks

Investment in DIV does involve some of its own risks. And the major ones as I see are detailed below.

First, the total return of DIV does not compare favorably with the overall market or other dividend funds such as VYM. This should come as no surprise given DIV’s emphasis on high current dividend yield.

The second risk is a bit of a surprise for me. As aforementioned, DIV attempts to achieve a high dividend yield with low volatility. As mentioned by the issuer’s fund description (the emphasis were added by me):

DIV's index methodology screens for equities that have exhibited low betas relative to the S&P 500 in an effort to produce low volatility returns.

However, as seen from the data below, DIV doesn’t really deliver the low volatility it attempts to deliver. The fund actually suffered higher volatility than comparable funds such as VYM AND also the overall market – much higher, especially during market crashes. As can be seen, it has experienced a higher standard deviation, a worse worst year performance, and a much larger maximum drawdown compared to both VYM and the overall market.

As seen, in the recent 2020 COVID crash, it suffered drawdowns of more than 45%, more than 2x of the overall market (about 20%). I think the reasons for its large volatility are twofold. First, it's limited to 50 stocks. And second, in pursuit of dividends, DIV invests heavily in mid-cap and small-cap stocks compared to VYM and SP&500, therefore, leading to higher volatility risks.

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

Conclusion and final thought

This article discusses DIV’s income generation capability, particularly with a focus on the preservation of income under the current inflation risks and the fund’s large volatility risks. The main takeaways are:

1. The pros. Its high current dividend yield of 5.5% is well above the expected inflation. At the same time, its yield also provides a healthy spread against treasury rates. Such a yield spread creates an attractive opportunity for investors to hedge inflation and interest risks.

2. The cons. The total returns of DIV do not compare favorably with the overall market or other dividend funds such as VYM. This should come as no surprise given DIV’s emphasis on high current dividend yield. Moreover, DIV actually suffered significantly higher volatility risks despite its goal of achieving low volatility. In the recent 2020 COVID crash, it suffered drawdowns of more than 45%, more than 2x of the overall market (about 20%). So if you are a potential investor, you need to be aware and prepared in similar turmoil times if you rely on this fund’s income.

3. Hedging ideas. Historically, equity funds such as DIV has been negatively correlated to long-term treasury bonds in the past and showed no correlation with gold. Given such a negative correlation or lack of correlation, you could consider setting up a combined portfolio consisting of two or three of these negatively correlated assets for hedging. You do not need to hold too much treasury bonds or gold. Holding about 10% of each would substantially hedge a large portion of the volatility risks already as shown in my previous articles. Of course, these hedging methods will reduce your dividend income a little bit (probably by about 10% or so). But reducing the drawdown can be worth more – both in economic and emotional terms – during market turbulence.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within 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.