The current domestic equity market has been increasingly weighted toward tech-related stocks.
SDOGX’s equal weighting scheme reduces sector bias that can be found in broad-based U.S. equity indexes like the S&P 500. While the S&P 500 is broad-based in the sense that it represents the larger market, its sector diversity has actually diminished over the years. One of the most noticeable changes to the U.S. market has been the growth of the technology sector, and these companies have some of the highest market caps within the domestic equity space. Because of the S&P 500’s market-cap weighting scheme, it has been tilting increasingly tech-heavy throughout the years, while underweighting sectors like materials, utilities, and energy. As of February 28, 2022, 28.1% of the S&P 500 by weighting was focused on technology stocks—significantly more than the 19.0% weighting around 10 years ago. Besides mega-cap technology companies like Apple (AAPL) and Microsoft (MSFT), the index’s top 10 constituents include companies like Amazon (AMZN), Google (GOOG), Tesla (TSLA), and Facebook (META) that are not officially classified as technology stocks but are still heavily related to the tech sector. While it is unlikely that many have been bothered when the weighting of these mega-cap tech and tech-oriented stocks contributed to higher index returns, the disadvantages of concentrated exposure become more apparent when the tech sector does poorly—as it did in during in early 2022. YTD through February 28, the S&P 500 had a total return of -8.0%, while SDOGX was able to achieve a total return of +1.3%. The technology sector as measured by the S&P 500 Information Technology Index (S5INFT) fell 11.4% YTD—and as mentioned earlier, the S&P 500 currently weights the technology sector at 28.1% vs. 9.6% in SDOGX. On the other hand, the energy sector as measured by the S&P 500 Energy Index (SPN) returned 27.6% YTD. The S&P 500 has not been able to benefit from this sector’s performance given its current 3.7% weighting toward this sector vs. 10.9% in SDOGX.
In addition to sector diversity, SDOGX is constructed to find cheap stocks through high dividend yield.
While the tech sell-off has highlighted the consequences of concentrated sector exposure in broad equity indexes, many dividend index strategies also have biases on both the sector and stock level. One approach commonly used by dividend indexes focuses on stocks that have consistently grown dividends for several years. This strategy leads to low, yet sustainable yields with little turnover among constituents over the years. Other dividend indexes may focus on high yields, which tend to overweight sectors like financials or healthcare. SDOGX’s equal weighting provides sector diversity, while selecting stocks with the highest dividend yield at the end of each year. The strategy is constructed to pick stocks that are the cheapest in their sector, with the assumption that prices will appreciate throughout the year and revert to the mean. At the end of each year, the companies with lower yields are removed and replaced with cheaper, higher yielding stocks, which gives the index opportunity to again capture price improvement from discounted companies while taking advantage of high dividend income.
Current Yields vs. History
Midstream/MLPs offer both attractive yields and the potential for total return. Strength in energy prices and inflation concerns have contributed to a strong start to 2022 for midstream/MLPs compared to other sectors.
Yields offered by Sector Dividend Dogs are about in line with their five-year averages, with the yield for the S-Network Emerging Sector Dividend Dogs Index (EDOGX) a notable exception.
Multiple screens for dividend durability, including evaluating cash flows, EBITDA, and debt-to-equity ratios, help ensure reliable income from the durable dividend indexes.
Current yields are near historical averages, and closed-end funds continue to represent an attractive option for enhancing the yield of an income-oriented portfolio.