Thanksgiving isn’t just a time for giving thanks, for some investment professionals, it’s an occasion for market
research. Between squabbling cousins and the Lion’s annual shellacking, an
attentive listener can tell how far the incipient correction has run just by
the questions asked around the dinner table. Is your grandmother asking about
CD rates, while your crazy uncle talks non-stop about gold as a store of value? If so, then the correction might
have a lot more room to run as your relatives “de-FAANG” their portfolios to
make room for “safe” investments.
Fortunately for the markets, not every investor is
rushing to de-risk their portfolio by turning back to cash. Instead, some turn
to dividend funds for their combination of lower volatility and income
potential, with many of the products from the largest sponsors like Vanguard
and State Street seeing substantial inflows. However, a frequent topic we
discuss is that not all dividend funds are created equal, something now more
important than ever thanks to the latest correction.
Dividend income funds typically fall into one of two
categories: Some funds simply pick the highest dividend payers from a limited
universe, like the S&P 500, which typically leaves you with a lot of
utility and consumer staples exposure and not much else. The other category is
made up of funds that apply highly complicated formulas dependent on long-term
accounting data to determine whether a dividend is sustainable. This approach
winds up with a much smaller, more highly concentrated fund built using
outdated information. We went looking for funds that could bridge the gap
between those two approaches and found a new fund sponsor with a series of
products that could offer the best of both worlds.
Advisors Asset Management, founded in 1976, isn’t new to
the world of investment solutions, although their first forays into the world
of Exchange-Traded Funds only date back to November 2017. Their fund lineup is
devoted to the dividend or equity income space with the AAM S&P 500 High
Dividend Value ETF (SPDV) and the AAM S&P Emerging Markets High Dividend
Value ETF (EEMD). SPDV and EEMD now have one-year track records and will soon
be joined by the AAM S&P Developed Ex.-U.S. Dividend Fund (DMDV), which is
launching at the end of November. At first glance, their two current products would
seem to fit the mold of another series of generic dividend funds, especially if
ETF names are any judge of the actual strategies, but don’t be so quick to
judge these books by their cover.
Their names are accurate in defining their respective
geographic focuses and, as most obvious in the case of SPDV, all three rely on
indices provided by S&P Dow Jones where having a high dividend is just one
of the attributes for which they screen. In fact, their funds have abbreviated
names that cut off the reality that their respective benchmarks are built not
just on dividend yields, but free cash flow (FCF) yield as well. As we’ve
pointed out, looking at just high dividend yields is a sure-fire way to wind up
with a stealth utilities fund, but that’s only one potential danger. A much
bigger one is when a company’s share price has been beaten down, resulting in a
high dividend yield, but which may prove to be an accounting illusion. Just ask investors in General Electric (GE).
Instead, all three AAM products rely also on free cash
flow (FCF) yield to help determine dividend sustainability in building out
their portfolio’s. Why use FCF to judge sustainability? There’s a wealth of
information available from S&P Dow Jones on the past returns for high
dividend payers with strong free cash flow, but a simpler answer is found in
basic corporate finance. Dividends do have to be “paid” for, as earnings that
could go towards acquisitions or capital expenditures are returned to
shareholders instead, making FCF the most direct way to measure the ability of
an enterprise to sustain itself. But
another, and perhaps more visceral, answer is that FCF is often free of the
accounting distortions present in most quarterly and annual reports using GAAP.
All three funds rely on the same process for building out
their portfolios, although they have vastly different selection universes. SPDV
obviously begins with the S&P 500, while EEMD utilizes the S&P Emerging
Plus LargeMidCap Index with distinct liquidity constraints that keeps the
equally-weighted allocation from having a small-cap feel. Twice a year the
index provider will rank every constituent in the respective universes by
dividend and free cash flow yield over the trailing 12 months with the
components whose yields are in the bottom and top 2.5% percentiles will have
their yields adjusted to match those on the threshold. That relatively minor
modification helps keep both portfolios from being overly impacted by those
outliers we already mentioned whose yields might look distorted thanks to a
major price hit. A good example would be S&P component L Brands (LB),
currently sporting a dividend yield north of 8%, following a more than 50% drop
YTD.
But those ranks are only part of the process; both the
dividend and FCF scores are normalized and then combined to arrive at a final
score which determines the actual allocations. In practice, this means a stock
needs to have both an attractive FCF and dividend yield within their sector to
make the cut into the portfolio. The timing of their last reallocation in July,
near the peak of the market, meant that SPDV and EEMD have very distinct value
orientations, along with smaller average overall market caps than the average
large value or emerging market equity funds.
AAM’s process might seem straight forward, but not so
much so that you create a portfolio of just utilities and consumer staples
stocks. In fact, their funds are designed to keep just that from happening
thanks to a weighting system that puts the top five highest scoring stocks in
each GICS sector into each fund rather than just packing the funds with the top
highest scorers overall. Next, the individual components are equally weighted,
which gives the fund higher exposure to traditional defensive sectors like
utilities and consumer staples than you would find in the S&P 500.
Additionally, this process still enables exposure to more core or growth
sectors like technology, while avoiding going all-in on late-cycle value traps,
like bank stocks.
Now throw the shortly-to-be-launched DMDV that will fill the
gap in the AAM line-up. As the name implies, the fund relies on the S&P
Developed Ex-U.S. Dividend and Free Cash Flow Yield Index to offer exposure to
select dividend paying stocks in developed markets, while excluding not just
the United States but South Korean stocks from its portfolio as well. DMDV will
follow the same index rules that govern its two existing products, making it
easy for current investors to understand, but a challenge for investors used to
simpler funds. Unfortunately, investors that haven’t found the AAM series yet
could find themselves missing out on a significant new trend in dividend income
funds.
The net result of AAM’s portfolio construction strategies
and, why we’re so interested in the AAM series of funds, is that they tend to
have a higher correlation to the broader equity markets than most dividend
funds while retaining most of the advantages of their competitors. While a
one-year track record isn’t the most exhaustive we could hope for, a factsheet
provided by AAM points out that their largest fund, SPDV, had outperformed a
host of other funds tied to the S&P 500 in 2018 through the end of
September. This outperforming occurred while delivering a comparable dividend
yield and slightly lower volatility and downside capture than other funds in
the space. How they did that was by
having a slightly higher correlation to the S&P 500, which allowed it to
pick up a significant chunk of the market’s gains in the first half of the year
while not taking in all the losses on the back end.
How does that translate into actual performance during a
period of higher volatility? Both SPDV
and EEMD have outperformed their broader categories over the past month
(through 11/27), as tech and energy names have sold off, while even interest
rate sensitive utilities haven’t been spared the rod. That’s helped SPDV’s more balanced approach
find some favor, a major challenge at this point considering its current
allocation dates to last July. However, the fund will undergo a reconstitution
again in January and the need to have representation to every GICS sector will
ensure a more diversified portfolio no matter what.
A good way to understand their strategy is to study the
biggest winner in SPDV’s portfolio over the last three months, consumer staples
favorite Walgreens Boots Alliance Inc (WBA), up over 18.5%. SPDV’s 2.4% allocation is hardly the largest
out there, we show 17 other ETF’s with larger positions but those are almost
entirely by pure consumer staples funds, typically not a big “must have” for
individual investors. Only the titanic
Vanguard Dividend Appreciation Fund (VIG) has a position even close to 2% with
most funds having positions of 1% thanks to a broader portfolio with hundreds
of positions. SPDV’s focus on only the
top five in each sector means a much more concentrated portfolio of “best
names” rather than an “anyone-can-come” solution.
That sector rotation has hurt some larger dividend funds
but that’s only part of the story. A
clear rotation out of technology stocks isn’t the only noticeable trend of the
past few weeks, developed market stocks have begun to outperform their U.S. peers. Answering why that is could make even the
most easygoing economist froth at the mouth. Disparate central bank policies
and a worsening of the U.S. economic outlook are the most commonly cited
reasons for this, although that “why” isn’t all that important. That investors are looking for more
diversified sources of income is what counts, making the launch of DMDV all the
timelier.
So, while the AAM series of dividend funds might be new,
they have already begun to demonstrate their value to investors looking for a
more balanced approach to equity income.
Thanks for reading ETF Global Perspectives!
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