Sunday, December 16, 2012

3 Reasons Why Most Dividend ETFs Will Fail

Today, there are some 50 dividend ETFs in the U.S. market with approximately $50 billion under management between them. A few years ago, there were only a handful of them to choose from. Thanks to the growing investor demand for income, however, they have rapidly attracted assets and, naturally, new ones seem to spring up each month.

In five years' time, I expect most of them to have gone the way of the Dodo, or at least have altered their mandates, as investors will eventually either a) be underwhelmed by their performance and/or b) find lower-risk alternatives for generating income and consequently take their money elsewhere.

Here are three reasons why I think that will be the case.

#1) They're basically closet-S&P 500 trackers with higher expense ratios

Most of the highly-liquid, higher-yielding stocks (the Exxons, GEs, etc.) are already found in the S&P 500, yet you'll likely pay at least 0.3% for a dividend-themed ETF versus 0.1% or less for an S&P 500 tracker. 

As this one-year performance chart comparing SPY with five of the larger dividend ETFs by AUM illustrates, you haven't been getting what you paid for. In fact, SPY was the best-performing of the lot. 

Source: Google Finance, as of Dec. 15, 2012
#2) Serious dividend investors can replicate the strategy on their own at a lower cost

An individual investor with a firm understanding of stock selection and portfolio construction could put together a diversified basket of individual dividend-paying stocks on their own -- that also better matched his or her risk tolerance and objectives -- and do so at a lower cost in the longer-term assuming they don't actively trade. 

Experienced dividend investors already know they can build their own portfolios and aren't the ones pumping money into dividend-themed ETFs. As such, I suspect that most of the money that's been invested in dividend ETFs over the past eighteen months has come from financial advisors hoping to eek a little more income out of their clients' portfolios in a low-rate environment, and that once interest rates rise (or tax rates change), they'll gradually switch their clients back to fixed income products.

#3) Dividend ETFs will be slow to adjust to changes in the market environment

It seems that each new dividend ETF that hits the market claims to have some kind of edge over the others -- "quality", "dividend dogs", and so on -- and they've all done backtests to show how their strategy would have worked over the past x number of years. 

The thing to keep in mind is that the dividend environment has changed dramatically over the past ten years and will likely change even more in the next ten. Since 2003, for instance, U.S. dividend tax rates were dropped to historic lows, the financial crisis led to hundreds of dividend cuts, and buybacks eclipsed dividends as the primary way that companies return shareholder cash. 

Looking forward, U.S. dividend taxes will go up in 2013 and that will certainly have a meaningful effect on corporate dividend policies in the coming years. All this is to say that dividend ETFs that construct their portfolios based on strategies that worked in the past may find that their formulas do not work going forward. 

My rule of thumb here is, the more "boutique" the dividend theme or strategy in an ETF, the more likely it will struggle to adjust to changing market conditions.

Bottom line

This is not to say that all dividend ETFs are doomed or unworthy of investment, but to be careful about which ones you choose. A number of them will be survivors, and they'll likely be the ones with the lowest expense ratios and broadest diversification. Sadly, those are also usually the ones that most-closely track the S&P 500 and offer the lowest yields. 

If you really want to give one of these new specialized dividend-themed ETFs a try, do proceed with caution. Don't focus on backtested performance, but focus on the fund's stock selection process. 

See you in 2013!

This will likely be my last post in 2012, so I wanted to say "thank you" for reading this year and to wish you a great holiday season. 

I also recently started up a dividend investing community on Google Plus, which you can join by clicking here (free with a Google account). It would be great to see you there!


@toddwenning on Twitter