Inside The Simple, Surprisingly Effective Dividend ETF

by on January 4, 2012 | ETFs Mentioned:

Sometimes the simplest solution is the most effective. That certainly seemed to be the case when it comes to dividend-focused exchange-traded products in 2011. As investors have sought to enhance current return profiles while scaling back the risk of equity investments, the landscape has become cluttered with ETPs targeting stocks of dividend-paying companies. Currently there are more than 40 ETFs  linked to indexes that employ a dividend-focused methodology to determine holdings, including both products that seek to maximize current yields and those that value consistency and stability of dividends over magnitude [see A Tale Of Two Dividend ETFs].

Some of these products utilize rather complex weighting methodologies and selection criteria to assemble a basket of dividend-paying stocks. And then there’s DOD, one of the least diversified and simplest exchange-traded products available to U.S. investors. The results, however, have been mighty impressive over the last couple of years.

Under The Hood

DOD is linked to the Dow Jones High Yield Select 10 Total Return Index, a benchmark that replicates an investment strategy that has been around for decades. Better known as the “Dogs of the Dow,” this approach involves selecting the ten stocks from the 30 that make up the Dow Jones Industrial Average with the highest indicated annual dividend yield. Each December, the Dow components are ranked by their distribution yield, and the ten that rank the highest are selected for inclusion [see DOD Holdings]. That’s it – no multi-level screens, and certainly not much in the way of diversification.

The strategy has contrarian roots; presumably, the stocks that have performed poorly over the last year would have depressed prices, which should translate into higher dividend yields. Of course, it’s very possible for stocks that haven’t been laggards to make their way into the benchmark–all it takes is a relatively attractive dividend yield. The Dogs of the Dow strategy was popularized by a book published in the early 1990s by money manager Michael O’Higgins, Beating The Dow. Since then, the approach has been followed as an alternative to traditional broad-based investing techniques, and has become somewhat popular with a wide range of investors [see Dividend ETF Investing: Four Critical Factors To Consider].

Last year, the stocks that made up the Dogs strategy was a list of well-known, blue chip firms–each of which boasted an impressive dividend yield on December 31. The Dogs for 2011 included AT&T (T), Verizon (VZ), Pfizer (PFE), Merck (MRK), Kraft (KFT), Johnson & Johnson (JNJ), Intel (INTC), DuPont (DD), McDonald’s (MCD), Chevron (CVX) [try our Free ETF Stock Exposure Tool].

For 2012, there are only a few changes; General Electric (GE) and Proctor & Gamble (PG) replace MCD and CVX:

2012 Dogs of the Dow
Ticker Company Yield
T AT&T 5.8%
VZ Verizon 5.0%
MRK Merck 4.5%
GE* General Electric 3.8%
PFE Pfizer 3.7%
DD DuPont 3.6%
JNJ Johnson & Johnson 3.5%
INTC Intel 3.5%
PG* Proctor & Gamble 3.2%
KFT Kraft 3.1%
*New addition in 2012

Dogs Have Their Day(s)

In 2007, the ELEMENTS Dogs of the Dow ETN was launched, allowing investors to access this strategy through the exchange-traded structure. DOD hasn’t been very popular, accumulating only about $5 million in AUM. But those who have bought into this note have likely been quite pleased with the results. DOD gained more than 15% in a less-than-stellar 2011, beating the Dow Jones Industrial Average ETF (DIA) by about 700 basis points. That margin was similar in 2010, when DOD tacked on more than 19% compared to a gain of about 13.5% for DIA.

Between the point when the U.S. stock market bottomed out in March 2009 and the end of 2011 DOD was up a healthy 180%, making it one of the best-performing U.S. equity ETPs over that period. The simplicity of the strategy has clearly not had an inverse performance on results; DOD has been quite effective at identifying large cap stocks poised to deliver strong gains. 

There is one quirk of DOD that may diminish the appeal to those seeking to boost the current income from their portfolios: this ETN doesn’t pay out dividends. Rather, dividends received from component stocks are reinvested–meaning that there will be no payout to investors for holding this ETN [see Back To Basics: 7 ETFs For Long-Term Investors].

It should also be noted that DOD charges a relatively hefty expense ratio of 0.75% for carrying out what is a very simple and straightforward strategy (perhaps the elevated expense ratio explains the meager asset base). Investors interested in this approach may be better off to eschew the exchange-traded structure in this case and construct the underlying stock portfolio on their own. 

Disclosure: No positions at time of writing.