From the February 2013 issue of Investment Advisor • Subscribe!

Equity Income ETFs: Incognito Sector Funds?

Over the past few years, as retail investors have fled en masse from equity funds to bond funds, dividend strategies have been one of the few categories of equity ETFs to consistently attract net inflows. For many investors, the allure of these ETFs comes from the association between dividends and mature, low-beta stocks, along with the potential to receive a stream of dividend income over time. As interest rates are expected to remain near historic lows for at least the next couple of years, we believe there is a strong likelihood that these ETFs will remain popular. However, a look at many of the largest equity income ETFs reveals significant sector biases, presenting risks that many investors may have overlooked.

It’s not surprising that dividend-seeking strategies have a tendency to be biased toward certain sectors, particularly those in which the majority of constituent companies have historically paid dividends. This was also true in the years leading up to the recent financial crisis, when it was not uncommon for equity income ETFs to allocate approximately half of their portfolio holdings to the financials sector. After all, during the preceding decade, these companies had made large, consistent dividend payments. Unfortunately, the risk of this sector bias was not fully realized until the floor fell out from beneath the financials sector in the fall of 2008.

Today, while sector biases in most equity income ETFs are not as extreme as the allocations made to the financials sector a few years ago, there are still significant overweight and underweight allocations found in most of these ETFs compared to the broader market, both increasing exposure to sector-specific risks and impacting relative returns. In particular, many equity income ETFs are currently overweight the utilities and consumer staples sectors, both of which have been stalwart dividend payers in recent years. Compared to the S&P 500, the five largest equity income ETFs (by assets) are overweight the utilities sector by an average of over 10 percentage points and overweight the consumer staples sector by an average of over nine percentage points (as of Dec. 31, 2012). Notably, as investor appetite for these “defensive” sectors has increased, both have surged to higher earnings multiples than that of the S&P 500, despite expectations of lower future earnings growth rates than the broader market.

Equally important in determining relative returns are those sectors that are avoided by equity income ETFs. In fact, the most pronounced sector bias currently found in most equity income ETFs is the drastic underweight allocation made to the information technology sector. While this sector comprises about 19% of the S&P 500, the five largest equity income ETFs currently allocate an average of only 5% to information technology stocks. In the past, the avoidance of the IT sector was easily understood, since many of these companies have tended to reinvest earnings rather than pay dividends. However, over the past five years, dividend payments by the S&P 500 IT sector have grown at a 21% annual rate and now make the largest contribution to total dividends paid out by the S&P 500.

Unlike actively managed mutual funds, sector biases for equity income ETFs are often the byproduct of index rules, rather than the expression of a portfolio manager’s fundamental outlook. For example, many equity income indexes require constituent companies to have a long-term track record of increasing dividend payments, stretching back as far as 25 years. As a result, ETFs that track these indexes are slow to adjust to emerging trends, such as the dividend increases that have characterized the IT sector over the past five years.

One solution to alleviate these sector biases is to selectively allocate to other individual sector ETFs within an investment portfolio to more closely track broad equity indexes. While such an approach may result in a slightly lower current dividend yield for an overall investment portfolio and increase trading costs, it may also increase the portfolio’s overall dividend growth rate, due to the augmented allocation to certain sectors. More importantly, however, the additional diversification may help insulate equity income investors from relative underperformance during periods of time in which defensive sectors, like utilities and consumer staples, fall out of favor.

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