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Dividend investing holds tremendous appeal during all sorts of market environments. However, products built around this timeless discipline are still exposed to key risks that frequently go unmentioned.
Below, ETF Database provides a guide to remind investors of the inherent drawbacks to the various types of income-seeking equity ETFs.
The Appeal and Drawbacks of Dividend ETFs
Not all dividend ETFs are created equal, so let’s review the two main breeds before we examine them in closer detail:
- Dividend-Weighted: These products are linked to indexes that screen and weight companies based on the absolute size of their distributions, often resulting in large cap-heavy portfolios closely resembling traditional cap-weighted benchmarks.
- Yield-Weighted: These products are linked to indexes that screen and weight companies based on the yield, not the absolute size, of their distribution, resulting in portfolios with greater exposure to small- and mid-cap securities.
The key considerations associated with each are as follows:
| - | Dividend-Weighted | Yield-Weighted |
|---|---|---|
| Appeal | Defensive, income-generating equity exposure with focus on consistent track record of distributions. | Juicy yield with potential for capital appreciation. |
| Drawbacks | Lackluster yield and lots of overlap in holdings with plain vanilla index funds. | Heavy concentration to highly speculative securities and/or a single sector/industry. |
Read more about dividend vs. yield weighting here.
Dividends at Risk: Oil & Gas Case Study
Let’s consider a real-life example of how dividend ETFs could see their safe-haven reputation come under pressure.
Oil Price Collapse of 2014-2016
Energy-related equities came into the limelight starting in 2014 when crude oil prices collapsed to below $100 a barrel. The situation only became worse for the sector as prices continued to sink, dropping to as low as $26 a barrel in 2016.
This fundamental headwind plaguing the entire oil and gas industry puts pressure on dividend-focused equity products in a number of ways:
- For dividend-weighted ETFs
Investors must deal with the changing reality that even the safest large-cap energy names are vulnerable, no matter how longstanding and impressive their distribution history may be. Take for example Kinder Morgan (KMI), North America’s largest pipeline operator, which was forced to cut its dividend by 75% at the start of 2015, highlighting that even the seemingly insulated MLP corner of the industry is vulnerable to steep declines in energy prices.
Furthermore, energy juggernauts like Exxon (XOM) and Chevron (CVX) are also under the microscope as they are forced to keep up with their dividend-paying culture despite suffering financial hardships in their day-to-day operations as a result of suppressed oil prices.
- For yield-weighted ETFs
Investors must stomach even more risk than is typically associated with high-yield equity products; the reason being that the smaller, riskier energy companies are at greatest risk of total failure when the fundamental conditions worsen this much. While blue-chip names like XOM or CVX can stomach making dividend payments when times are tough, many high-yielding names in the sector will see their payout ratios rise beyond sustainable levels, thereby resulting in eventual/inevitable dividend cuts.
Unless earnings rise for these firms in this type of scenario, which is a near impossible feat assuming energy prices remain suppressed, the energy companies composing yield-weighted ETFs may be vulnerable to stiff selling pressures.
The ultimate takeaway is this: low oil prices have resulted in poor earnings for the entire sector, which has inevitably raised payout ratios, thereby posing a threat to the sustainability of the distributions made by firms of all sizes; smaller, higher-yielding stocks are the most vulnerable to dividend cuts and price depreciation.
Ways to Play
Some of the most popular ETFs in this space include:
- Vanguard Dividend Appreciation ETF (VIG ).
- iShares Select Dividend ETF (DVY ).
- Vanguard High Dividend Yield ETF (VYM ).
- Schwab US Dividend Equity ETF (SCHD ).
- iShares International Select Dividend ETF (IDV ).
- S&P 500 Dividend Aristocrats ETF (NOBL ).
See the full list of Dividend ETFs here.
The Bottom Line
The timeless appeal of dividend investing has been a longstanding driver of demand for income-seeking ETFs; however, it is the defensive-minded nature of this discipline that can lure many into a false sense of security. Investors need to remember that dividend investing, much like any other discipline, be it value, growth, or swing trading, is prone to drawbacks and periods of underperformance.
In the case of dividend ETFs, their biggest weakness is the fact that the safety of their distributions, which is arguably their biggest appeal, is by no means a guarantee. Put another way, while there may be a sense of consistency associated with dividend investing, it’s far from being a risk-free endeavor.
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