Reality Shares CEO Explains Benefits of Smart Beta Dividend ETF Investing

ETFdb.com: Please tell us about yourself and your role as President and CEO at Reality Shares.

Eric Ervin (E.E.): I currently serve as President and CEO of Reality Shares, a firm solely focused on dividend-growth investing. Before co-founding Reality Shares, I worked at Morgan Stanley for 14 years, building a wealth management franchise as a CFP practitioner and chartered financial consultant. I, along with many of my clients, was often frustrated by the disconnect between the reality of a company’s performance and its stock price. I co-founded the firm in order to deliver low-cost, tax-efficient investment solutions for individual investors that could remove the market noise and focus solely on fundamental aspects of companies. At Reality Shares, we are solely focused on dividend-growth investing and we offer a range of alternative ETFs (DIVY, LEAD, DFND, and GARD) pinpointing and capitalizing on investment in dividend growth and the stocks most likely to increase their dividends, as well as avoiding those most likely to cut their dividends.

Use our Head-to-Head ETF Comparison tool to compare two Reality Shares ETFs, such as DIVY and LEAD, and find out the difference between them on a variety of criteria such as performance, AUM, trading volume and expenses.

ETFdb.com: Reality Shares differentiates itself since all four ETFs focus on dividend investing. What’s the reason for this focus?

E.E.: While there has been a proliferation of dividend-focused ETFs, there was traditionally a lack of innovation in that space. In addition, one fundamental disconnect we observed was the difference between the dividend growth of companies and their respective total return. While it would seem that dividends are highly correlated to the market, this is not always the case. As interest rates dropped to historic lows, investors could no longer rely on bonds, and there was a need for alternative strategies delivering absolute return. This is where “isolated dividend growth” came into the picture. Isolated dividend growth involves investing in the dividend growth rate of the market while avoiding stock market price exposure/volatility. As an example, an investor could capture the dividend growth rate of all the companies in the S&P 500 at an aggregate level without worrying about whether the individual stock prices go up or down; they are only concerned with whether or not dividends are rising, as that is the primary driver of returns. This is the premise behind the launch of our DIVY ETF – packaging this investment opportunity in a transparent, liquid and cost-effective wrapper for the masses.

As we further built out the firm’s strategy, we saw the need for more forward-looking, dividend-focused investment solutions. While backward-looking strategies like the Aristocrats and Dividend Achievers have some benefits, they also have some flaws. For one, companies with long histories of increasing dividends will not offer the same future dividend-growth potential compared to younger companies with solid fundamentals. Second, they are more prone to dividend cuts. For example, during the financial crisis from 2008 to 2009, there were 13 dividend cuts among the Aristocrats and 55 cuts among the Dividend Achievers (nearly 30% of the constituents of each index). An analysis conducted by Ned Davis Research shows dividend growers – companies with a dividend increase during the trailing 12-month period – have historically outperformed all other segments of the market (from 1972 through Q1 2017), with significantly less volatility.

For these reasons, we introduced our DIVCON® dividend health-rating system. DIVCON incorporates a quantitative factor-based methodology and uses a five-tier rating system to assess the likelihood of companies growing or cutting their dividends in the next 12 months, a true innovation in the dividend investing space. As the data has shown, dividend growers have historically outperformed the rest of the market. Our LEAD, DFND and GARD ETFs are based on the DIVCON methodology.

Check out ETFdb.com’s guide on High Yield ETF Investing.

ETFdb.com: Given such a unique strategy, what kinds of investors are you targeting who would be interested in Reality Shares ETFs?

E.E.: All four of our ETFs are designed for both individual and institutional investors and cover the broad spectrum of risk profiles and portfolio investment objectives. While DIVY could be a suitable equity allocation alternative, we believe DIVY is a fixed-income strategy alternative because it offers low volatility and low correlation to both equities and bonds. Think of DIVY as a diversifier for bonds. It can be included in a portfolio for the same reason bonds used to be considered – to reduce risk by offering stability and solid performance even during rising rate environments.

LEAD is designed as a large-cap equity allocation. As a high-quality portfolio of companies most likely to raise dividends in the next 12 months, LEAD offers the potential for better downside protection as it holds many of the names that institutional managers are least willing to sell, even during downturns. People should think of LEAD as an alternative to the traditional S&P 500 index at a fraction of the cost of an actively managed mutual fund or money manager.

DFND offers investors more of a balanced return. It tracks the market but aims to reduce the downside by utilizing a continuous hedged component that shorts the stocks most likely to cut their dividends. DFND is great for investors looking to stay in the markets at all times or to seek a solution during market underperformance. Think of DFND as being long on the high-quality dividend growers while hedging and shorting the lowest-quality dividend paying names.

GARD is meant for investors desiring some downside protection when the markets are in a negative environment, while offering upside when markets are positive. GARD was created to give investors an automated portfolio component that can dynamically allocate in and out of the market depending on the market environment alongside a position in the highest-quality dividend growers. It is an equity-oriented substitute with a defensive aspect.

ETFdb.com: There is a huge shift from active to passive investment management as almost $1 trillion in assets were moved in 2016, according to data from the Investment Company Institute. Why do you think that is and do you see this trend continuing?

E.E.: Before the introduction of ETFs and the proliferation of available products/strategies, most investors turned to actively managed strategies through the traditional mutual fund and hedge fund channels. These were high priced and, in many cases, highly inefficient investment solutions. Then came the first wave of plain-vanilla, index-based ETFs – what we call ETFs 1.0. Investors could mimic the performance of a variety of benchmarks (minus fees), achieving great returns at a fraction of the cost of actively managed strategies. In the past few years, we’ve seen the introduction and evolution of smart-beta ETFs and more sophisticated products – what we call ETFs 2.0 and now 3.0. As more investors flocked to plain-vanilla, passive-beta investments, fund issuers have found new ways to deliver even greater outperformance using factor-based and other more complex methodologies. This new wave of products gives investors the best of both worlds, still characterized as passive strategies with significantly lower costs than their actively managed counterparts, but with similar enhanced returns and performance attributes. Our suite of innovative ETFs offers the potential for market outperformance with attractive risk/return profiles.

ETFdb.com: What are some of the most important trends you are seeing in the ETF industry today?

E.E.: Over the years, ETFs have democratized the investment process. They give people access to the returns they want at a fraction of the cost and complexity of mutual funds and hedge funds. Investors should expect more ETF choices in general, which will be a good thing for actively trading on current market developments and thematic trading in anticipation of both broad market and specific industry trends. Additionally, as we’ve seen with the race to zero commissions among the leading brokerage firms, there is a similar trend with ETF fees continuing to move lower, especially on the plain-vanilla, passive-beta front. And there is, and will continue to be, a bigger push to introduce more innovative smart-beta products.

ETFdb.com: Most of the Reality Shares ETFs are considered smart beta. What is the future of smart beta in your opinion?

E.E.: The industry has evolved from plain-vanilla index funds to more refined, smart-beta ETFs as investors realize a plain-vanilla, passive-only approach leaves them vulnerable as more and more people pile into traditional cap-weighted products. This inspired them to try alternative-weighting strategies based on factors “smarter” than market cap. Smart-beta ETFs of the future will hold the best-performing stocks while avoiding the laggards and keeping costs to a minimum. These next-generation ETFs will offer alternative strategies focused on risk-adjusted returns with high upside capture, while simultaneously identifying and avoiding low-quality stocks. ETF companies like Reality Shares will continue innovating new strategies to access alpha-generating segments of the equity market while disintermediating the active mutual funds, which have delivered dismal returns while charging excessive fees. For example, our LEAD ETF has outperformed while costing less than 90% of all U.S. equity mutual funds.

One thing to be aware of is concentration. These smarter ETFs of the future will be comprised of far fewer constituents than a broad market index – perhaps only 30 or 40 compared to 500. If you believe in the quality of the weighting factor(s), less is more – investing in fewer high-quality names can be more beneficial than over-diversifying and investing in many low-quality names. This is the foundation of our DIVCON ETFs (LEAD, DFND and GARD).

For a full list of Smart-Beta ETFs, click here.

ETFdb.com: What other opportunities do you see in the coming future for Reality Shares ETF launches?

E.E.: Good question. Our company culture is very innovative and customer-oriented, so we are attentive to the needs and wants of our customers first and foremost when we think about possible product innovations. In fact, that’s how Reality Shares and I first got into the ETF space with DIVY – so many customers were telling us that they wanted an institutional-grade investment strategy in an ETF made accessible to the masses, so we built it for them. Now, two-plus years later, I’m glad we listened to what our customers were saying. Going forward, we’ll continue to listen to our customers as a guide to where they want to go with us.

We really like the fact that we are one of a select few, if not the only company, exclusively focused on dividend growth ETFs – which so many customers have been clamoring to own. Our priority for a new launch, therefore, would likely have its foundation in the dividend-growth ecosystem. We obviously are huge believers in dividend-growth investment strategies and know we have plenty of opportunity on the horizon with our current lineup of four outstanding ETFs. But again, from here we’ll go wherever our customers lead us to next, in terms of innovation and new product launches.

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Reality Shares provides investors with a good selection of smart-beta dividend-growth ETFs. As Eric Ervin stated, Reality Shares ETFs can be used to decrease overall portfolio risk with the potential for better downside protection. As discussed, passive ETFs with lower fees are becoming more popular with investors and that trend will likely continue. As for smart-beta investing, Mr. Ervin believes future smart-beta ETFs will likely have fewer overall holdings, but the quality of those holdings will be high.

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