Dividend investing, with all due respect, has become such a “me too” thing. Everybody’s seemingly doing it.
Investors and financial advisors alike have rediscovered the magic of dividends as a crucial element toward successful long-term investing. And the love affair with U.S. dividend paying stocks that’s been nurtured over the past several years has been fueled to a large degree by an environment of extremes.
The post 2008–09 financial crisis ushered in a scared — not brave — new world of rock bottom interest rates courtesy of freaked out central banks like the Federal Reserve. The resulting aftermath has led to a hyper-low yield situation, which in turn has caused traditional income investing sources like corporate and government bonds to lose their appeal.
Although dividend paying stocks may be popular right now, how will they hold up if market conditions change for the worse? In this article, we’ll examine three different market scenarios — each with its own challenges — and why dividend investing can still be a powerful ally.
When Rates Rise
During periods of rising interest rates, stocks have historically appreciated in value. However, not all stocks or sectors have particpated in the gains.
A snapshot of five selected periods of rising interest rates since Oct. 1993 shows that utilities and the telecommunication services sectors consistently posted negative performance, according to a study conducted by The Boston Company Asset Management. The lone exceptions were outlier years like 2003 for utilities and 1998 for telecom, when both sectors rose in value.
If rate sensitive industry sectors like utilities underperform during a market cycle of higher interest rates in the future, dividend funds like the iShares Select Dividend ETF (DVY) with substantial exposure to utilities could take a hit.
One path toward balancing the need for dividend income with controlling sector specific risk is a novel approach taken by the ALPS Sector Dividend Dogs ETF (SDOG).
Instead of loading up on high yielding sectors, SDOG evenly divides its dividend exposure across all 10 sectors of the S&P 500 by selecting the five highest yielding securities in each sector. Each stock gets 2% representation while each sector’s market exposure is capped at 10%.
“By expanding ‘Dogs of the Dow’ theory to each sector of the S&P 500, SDOG retains the high dividend yield and deep value characteristics of the Dow strategy, but with much better sector diversification across a broader universe of stocks,” said Jeremy Held, director of research at ALPS Advisors.
SDOG’s 50-stock portfolio is rebalanced quarterly and holdings are reconstituted at the end of each year. The fund’s 30-day SEC yield is 4.07 % and the fund charges annual expenses of 0.40%.
Ultimately, advisors should be cautious about dividend paying funds or ETFs with significant exposure to rate sensitive sectors when the risk of higher rates is imminent. Mitigating these risks with a more even sector approach to dividend investing is the prudent course.
During a period of high unemployment, rising commodities prices and sluggish economic activity, the role of dividends takes on greater meaning. Since growth from equity returns are frequently scant, dividends can serve a dual purpose of cushioning downturns and making for the lost ground.