Thursday, August 20, 2015

New-to-Market: CDL

New-to-Market - This blog series highlights ETFs that have recently gone public and reflect those strategies currently most in demand by investors. While ETFs are not eligible for ETFG Risk Ratings until traded for 3 months and ETFG Reward Ratings for 12 months, our goal is to highlight the most cutting-edge investment strategies that have recently embraced the ETF structure – we hope you enjoy this special series of posts.

Our “New-to-Market” series finds products offering something more than just a better mousetrap, so you can imagine our surprise when we found ourselves drawn to the saturated high dividend fund space to review the recently released Compass EMP US Large Cap High Dividend 100 Volatility Weighted Index ETF (CDL).

With 67 different funds and nearly $88 billion in assets largely dominated by the biggest names in the ETF market like Vanguard, iShares and SPDR, the high dividend category may not seem a likely place to find innovative products, but CDL is the seventh new fund to enter the space in 2015 as smaller sponsors seek to challenge the handful of solutions that have dominated the marketplace for over a decade.  How it seeks to do that is by combining the best features offered by the largest funds and for a reasonable 35 bps a year in fees.  If you’ve been torn between a high dividend yield today or a sustainable dividend tomorrow while potentially taking on less volatility, the Compass EMP US Large Cap High Dividend 100 Volatility Weighted Index ETF might just be the fund.

While the fund’s benchmark is the CEMP U.S. Large Cap High Dividend 100 Volatility Weighted Index, that benchmark is itself derived from another index, the CEMP U.S. Large Cap 500 Volatility Weighted Index that has been offered as an open-ended mutual fund by Compass since 2012.  The focus of the fund is strictly on larger U.S. equities although the benchmark’s universe consists of all domestic equities that is first whittled down using only one criterion, profitability, specifically four consecutive quarters of what the managers call “consistent” profitability.  The goal is to avoid buying “dividend traps” or those stocks whose high dividend yield is because of a recent decline in price usually due to some major change in the company’s financial status.  Screening companies based on profitability is nothing new; the sector heavyweight, Vanguard’s Dividend Approach Fund (VIG), operates on a similar principal but rather than screening based on underlying profitability of the business, Vanguard focuses on companies that have raised their dividends each year for at least the last ten consecutive years. VIG then allocates using a market cap weighting system which stretched across 184 holdings gives the fund the feel more of a large blend core fund and a yield only fractionally above an S&P 500 index fund.  Compass screens explicitly on dividends with the 100 highest dividend payers from the Large Cap 500 Volatility Weighted benchmark becoming part of CDL’s benchmark.

Perhaps the most evolutionary aspect of the fund’s benchmark is the volatility weighting system that the management team at Compass hopes will keep the fund’s volatility low and its risk-adjusted return high. Investors have long been familiar with the ramifications of indexes weighted by market capitalization; as a sector or even just a handful of names become investor darlings, their volatility tends to increase while simultaneously driving an increase in price with the net result that market becomes beholden to its new masters.  Think of market cap weighting as a double helping of portfolio risk and Compass seeks to manage that risk by weighting the benchmark components not by market capitalization but by their volatility. CDL determines individual position weights during semiannual reconstitutions by first determining the daily volatility of all 100 components over the prior 180 days then estimating the mean volatility and finally adding or subtracting from position weights accordingly.  The net result is that the largest ten stocks that make up just 15.4% of the fund at the moment have a strong focus on consumer staples, insurance and bank stocks while the more volatile energy and consumer discretionary names bring up the rear.  But for those potential investors who think a focus on dividends and low volatility means buying another utilities fund should have no fear because the portfolio has one other constraint besides profitability; namely, that no one sector can make up more than 25% of the portfolio’s allocation - utilities comprise the largest weighting at 22% thanks to their low volatility and steady profits.

We tend to view backtested results with a grain of salt although the straightforward strategy of CDL lends credibility to the impressive history where the fund’s hypothetical results showed an annualized alpha of 3.72% for the ten year period ending June 2015.  We believe in taking new funds for a test drive and even though CDL has only been in the market place for six weeks and is currently thinly traded, we decided to contrast the funds’ performance with that of the #2 fund in the space and most direct competitor, the iShares Select Dividend ETF (DVY) which also uses a unique weighting system that gives higher weights to higher dividend paying stocks. Both funds have 99 holdings and because of their unique weighting systems also have lower average market caps than most of their peers although CDL lands firms in the large value space with an average weighted market cap of $27 billion while DVY’s $15.7 billion puts it in the mid-cap value box.  They even have similar expense ratios with CDL and DVY at .35% and .39% respectively!

And while they might look alike and talk alike, they surely don’t act alike as CDL has returned 2.44% from inception through 8/19 compared to DVY’s .29% thanks in large part to their different weighting systems. Utilities are a large part of both allocations with DVY holding over 33% to CDL’s 24% but one major difference between the two funds is their allocation towards energy stocks where CDL has slightly more than half the exposure of DVY. And because of DVY’s dividend weighting system, energy stocks occupy much larger allocations within the portfolio; Helmerich & Payne’s (HP) has inflicted some trauma on DVY because of its 1.45% weighting (compared to .49% for CDL) and even more damage has been done by Chevron (CVX) whose 14% drawdown has weighed heavily on DVY thanks to an allocation more than 3x higher than that of CDL.  But there’s more to it than simply avoiding energy stocks; both funds hold trash king Republic Services (RSG) which is up 7.9% since the launch of CDL, but because of the stocks lower volatility CDL has a 1.47% allocation to the stock where DVY has less than half that at .7%.

With time the Compass EMP US Large Cap High Dividend 100 Volatility Weighted Index Fund might not prove itself to be the fund for all seasons, but for those demanding investors who want both dividend income and lower volatility, this fund might be a welcome addition to the portfolio.

Thank you for reading ETF Global Perspectives!

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