Near-term interest-rate risk doesn't change the core qualities that investors should look for in dividend-strategy exchange-traded funds.
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Despite the Federal Reserve's pullback on its tapering plans, investors remain spooked by the prospect of rising rates this Halloween season. Fixed-income investors aren't the only ones with cause to worry; dividend exchange-traded funds, a popular strategy during the recent years of record low rates, are also sensitive to rate increases. Dividend ETFs are not made equal, however. Their portfolios can vary widely from strategy to strategy depending on the methodologies of the indexes they track. Two of the largest dividend-strategy ETFs, Vanguard Dividend Appreciation ETF VIG and iShares Select Dividend DVY, have such different methodologies that only 17% of their portfolios overlap. So, because dividend strategies can differ so much, they'll be impacted differently by rate increases. Today, we pop the hood and see which of the largest and most popular dividend-strategy ETFs are most appropriately positioned to help investors gather dividend income without taking on significant interest-rate risk.
Now that the Fed has backtracked on its suggestions of tapering, is it realistic for investors to remain concerned about very near-term policy-rate increases? We think not, for a variety of reasons. First, the upcoming personnel changes at the Fed should calm some fears. Janet Yellen, a longtime proponent of monetary easing, is likely to be confirmed as the next Fed chair and is unlikely to set the Fed on a new course before next year at the earliest. Also, the economy's continued slow growth also indicates that rates are unlikely to dramatically tick up. At Morningstar's ETF Invest Conference in early October, Vanguard's chief economist Joe Davis said GDP growth is unlikely to rise out of the 2% range in the next 12 months.
In the less-immediate term, however, rates are likely to tick up. Vanguard expects tapering to begin before the end of the year and the Fed's policy rate to tick up in 2015. Morningstar bond strategist Dave Sekera also believes rates will meet the historical average over the long term. In aggregate, investors should be less concerned about rate increases in the near term and more focused on their long-term asset allocation as rates gradually rise over the next five to 10 years. If rates are likely to increase in coming years, what does that mean for the different dividend ETFs?
Rates tend to increase when the economy is experiencing accelerated growth. During such a situation, rising rates can be a headwind for dividend stocks because they compete with fixed income and growth stocks. Although dividend-paying companies provide stability and tend to have stable cash flow regardless of the interest-rate environment, they also have less growth potential than non-dividend-paying stocks from cyclical and speculative sectors. If the economy is booming, stable stocks don't generate as much investor demand as those from sectors like manufacturing or durable goods, which stand to benefit the most from economic growth. Dividend payers tend to outperform in stable or declining-rate environments, but struggle when rates are on an upswing. Sorting the market for dividend yield shows that the highest-yielding third of stocks had the worst historical performance in rising-rate environments.
Despite the potential for underperformance in a rising-rate environment, investors shouldn't throw out dividend stocks in preparation for a higher yield on the 10-year Treasury. Investors with rates on their minds should look for several qualities in a dividend-strategy ETF: sector allocation, dividend growth, and quality.
When rates rise because the economy is growing at a healthy clip, defensive-sector stocks in particular become an expensive trade. Morningstar fund analyst Alex Bryan discussed this topic in his article "The Hidden Risk of Investing in Stable Companies." Historically, defensive-sector stocks underperformed the broad U.S. equity market when rates were rising. The negative correlation between defensive-sector return and interest rates is notably damaging for utilities and telecoms. These firms are heavily regulated, which severely reduces their ability to grow at the same rate as other equities during an economic boom. Other rate-sensitive sectors include health care, financials, and tobacco. Josh Peters, the editor of the Morningstar DividendInvestor newsletter, made the case in a video last week for staying defensive in the long run. However, he reminded viewers that these stocks are likely to underperform the market in coming years as rates rise.