Many investors could find the process of weeding through a vast—and still growing—roster of dividend-focused equities ETFs mind-boggling these days, because there are so many funds out there offering their own take on the same theme, but one thing is certain:At times of increased market volatility—thanks to a global economy that has yet to find a strong footing, following the credit crisis of 2008—dividend stocks do more than generate income, WisdomTree’s Director of Research Jeremy Schwartz told IndexUniverse Correspondent Cinthia Murphy in a recent interview. They are actually quite good at mitigating volatility in a portfolio.
Murphy:Why do you see dividend-weighted approaches as a better way to manage risk exposure than a more traditional market-cap approach? What makes dividend-focused portfolios such a good idea?
Schwartz: About six years ago, when we launched 20 dividend funds in one day, we wanted to come out of the gate with a real alternative to market-cap-weighted strategies. Our goal was to allow investors to be able to do asset allocation in dividend baskets because there were few alternatives to market-capitalization indexes in the ETF market. Today the market environment is even better for dividend stocks than it was six years ago:Interest rates are at historical lows; the yield on 10-year Treasurys is very low; the traditional sources of income have all but dried up.
There’s also more of a concern today that the 30-year bull run in bonds will eventually reverse, and you also have an aging demographic that is looking for higher income and lower volatility. Dividend stocks typically deliver that.
Murphy:Is this marketing push for dividend stocks a trap for investors who could be forgetting that, dividend-paying or not, these are equities and therefore are more volatile than bonds, and could get them caught in a downdraft?
Schwartz: I don’t think it’s a trap, but you have to know your risks. Stocks are more volatile than bonds, but a bond can also face capital losses. There are different risk profiles you need to keep in mind when you are looking at what you want to hold for a longer period of time.
If you buy an individual 10-year Treasury bond and hold until maturity, you know with high confidence what your return will be. Prices can change on those bonds, but if you hold to maturity, that is largely irrelevant. Stock prices of dividend payers, on the other hand, fluctuate on a daily basis, and people monitor that.
I believe one should focus more on the stable income stream longer term, because checking that change on a daily basis will make you nervous and potentially prone to sell at inopportune times. If you look at the average dividend per share in the S'P 500, it has averaged 5 percent a year for the past 50 years and is fairly stable. Yields on a 10-year Treasury right now are 1.81 percent, and the average large-cap dividend-paying stock in the U.S. is over 3 percent. If investors can either stomach the daily volatility or not watch price moves daily, I believe there is better value in the dividend stocks.
Murphy:Is a bond ladder a better way to get exposure in terms of yield?
Schwartz :It’s not better; it’s just another way. They have different yields. A two-year Treasury bond is yielding 30 basis points, a five-year Treasury bond 79 basis points, and the 10-year U.S. government bond is at 1.81 percent. These are very low yields, and then you have to worry about the inflation impact on those bonds, which is likely to average 2 percent a year or more for the next decade. What I can say is that these bonds would not be for me. They are very expensive and their yields are very low.
Murphy:But that wasn’t always so, right? Is this the result of the 30-year bull run in bonds you referred to earlier?
Schwartz: Yes. Thirty years ago, you were looking at 12 to 13 percent yields on longer-dated debt, and now you are looking at 1.8 percent. There’s no real income there anymore.
Murphy:That could help explain the popularity of dividend-focused ETFs, I guess, and why we’ve seen so many pop up in the market recently. Is there a chance the dividend trade is getting too crowded?
Schwartz: Well, there are definitely more people trying to provide their own flavors of dividend funds, but I wouldn’t say there are too many. We were early into the game, which is good for us, but we have certainly seen more and more different ways to slice and dice the dividend market.
For us, when you look at the WisdomTree Dividend Index, it covers all dividend-paying stocks in the U.S. today—some 1,300 stocks. It’s like the Russell 3000 of dividend stocks. But fund providers are now adding more and more screens to this dividend space, acting more like active managers in a way, as they try to isolate the best dividend stocks through different filters to design narrower strategies.
Murphy:How is a retail investor to go about picking the right dividend ETF with so many to choose from?
Schwartz :It goes to back to under-the-hood analysis. When you look at a fund like WisdomTree’s LargeCap Dividend ETF (DLN) of 300 dividend stocks, you see a broad take on the large-cap dividend market. This is like the S'P 500 of dividend stocks. It makes sense to hold DLN as a core portfolio holding and add more active strategies or more active index strategies around it to find the highest-yielding stocks or the 100-best dividend growth stocks, what have you. But you have to know what you are getting.
If you look at Vanguard’s VIG, for instance, it might surprise you to see that the fund represents less than 20 percent of the large-cap market today, because of the screens that Vanguard uses in the strategy. Vanguard, which is a true indexing powerhouse, is in a way more like an active manager in VIG. Apple, for instance, reinitiated dividends this year and will be the third-biggest dividend payer in the U.S., but it is not included in VIG and will not be included for a long time, because VIG requires a stock to have increased dividends for at least 10 consecutive years before inclusion, among other criteria. Same thing with Cisco Systems—they just increased their dividend 75 percent. So you get a partial representation of the overall market. You need to know what you are getting.
Murphy:Should investors be concerned about sector tilts in dividend ETFs?
Schwartz: Not necessarily. You always need to look at the underlying exposure to make sure you are comfortable with what you are getting. When it comes to technology, for example, that “traditional” underweighting of technology in dividend ETFs is shifting because of companies like Apple, which has become the third-biggest dividend-paying stock in the market now.
Five years ago, technology names represented 5 percent of the total U.S. dividend market, and now the sector represents 13 percent. Tech companies have actually been the biggest sector growth in the dividend space. On the other hand, financials used to represent 30 percent of the U.S. dividend market five years ago, and now it is down to half of that, at about 15 percent, or $50 billion.
Murphy:So the sector weights are in a way irrelevant if what you are truly looking for is the best dividend-paying stocks regardless of sector diversification?
Schwartz: I’d say these weights are constantly being rebalanced to capture the dividend stream, at least in the case of WisdomTree’s indexes.
Murphy:What’s the relationship between dividend stocks and low volatility stocks? Is there an overlap here?
Schwartz: Dividend-paying sectors tend to be low-volatility sectors. Consumer staples, utilities and telecommunications, for instance, are often good dividend-paying sectors because people don’t want to short those stocks because of their high dividends; they are also more stable, from more mature companies, and they keep on paying dividends even in down markets. They are also low-volatility sectors.
But another important factor is that rules-based rebalancing helps to reduce volatility when valuations are overstretched. The MSCI EAFE Index was 60 percent allocated to Japan in 1989, and Japan saw negative returns for 25 years after that, dragging the MSCI EAFE down with it. Major bubbles like the technology bubble in the 1990s are another example of when valuations can get out of whack. Dividend-rebalancing weeds out stocks that have moved away from their fundamentals, reducing risk exposure, or volatility.
Murphy:What do you think of the minimum-volatility strategies we have in the market today?
Schwartz :Between 95 to 99 percent of ETFs follow market-capitalization-weighted indexes. In our view of the world, following one strategy for all the major asset classes within equities to bonds is not a sensible approach. In that sense, strategies that move away from strictly using market-cap-based indexes as the be-all/end-all are a positive for diversification.
Minimum-volatility ETFs are not solving that valuation concern—they are looking out for strictly low-volatility stocks, which may not have any relation to the relative prices of those stocks. One of the most popular minimum-vol ETFs is the PowerShares “SPLV,” which has approximately 60 percent of the portfolio allocated to two sectors:staples and utilities. Only 1 percent is tied to financials. I would argue this strategy is a more concentrated version of our dividend ex-financials ETF, which has no financials exposure and more balanced exposure in other sectors. But again, we go back to the importance of looking under the hood to know what you are getting.
Murphy:What are potential areas of innovation in the dividend space? Internationally?
Schwartz: Our international dividend ETF—DEM—is a $4 billion fund that has been around for five years. International dividend ETFs are already out there. But there’s the potential here to cover a lot more of the global markets through different tweaks in an almost active-management-like way to find the best dividend stocks in different markets. We continue to evolve on that front. We have, in fact, filed for a China dividend strategy, and we don’t have a lot of country-focused dividend ETFs in the market yet, so there are ways to slice the global space a little thinner.
Murphy:Is there a region that is particularly prospective?
Schwartz: The U.S. is actually a relatively low-dividend-paying country compared to others. In the Russell 3000, only 75 percent of stocks are paying dividends, and that number is more like 90 percent in many other regions. Different tax rules on dividend payments have a lot to do with the differences. India, for example, taxes dividends, so you see fewer dividends coming out of that market than you see in Australia, for instance, where the government gives tax credits to individuals for the dividends paid by companies.
The average dividend across the U.S. is about 3.2 percent, while the developed-markets EAFE is paying out 4.7 percent, annually. That is partly because European stocks are cheaper than U.S. stocks—they are trading at a discount—and also because of Australia’s high dividends, too. But the bottom line is that there’s a lot more slicing and dicing that could be done in the space globally.
Murphy:On a final note, to indulge Jim Wiandt’s curiosity, what are some unexpected ways you’ve seen people use WisdomTree funds?
Schwartz: When we first launched our ETFs in 2006, we really positioned ourselves as an alternative to market-cap-weighted strategies like the S'P 500. Our ETFs were to be alternatives to other index ETFs in the space. But we have also seen adoption of our products by financial advisors who are looking at our funds as competitors against active managers in addition to being an alternative to an indexed approach.
Another interesting way we’ve seen people use our funds is in terms of allocation. Traditionally, U.S. investors are heavily allocated to the U.S.—as much as 75 percent of their portfolios. But half of our assets are in emerging markets. People have really gravitated towards our emerging markets dividend strategy even though the U.S. market is so much bigger in size. Emerging markets have performed very well, so I can see the attraction, but still, the success of our emerging market funds relative to U.S. strategies is somewhat surprising.
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