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.