One of the most popular strategies at our firm is the Strategic Income Portfolio, which focuses on a multi-asset approach to generate consistent income and overall low volatility. In order to accomplish those goals, we continually scan the ETF landscape to evaluate suitable equity income funds that meet our investment criteria. These ETFs typically consist of high-quality stocks with above-average dividend streams and low internal expenses.
While every index is slightly different, one theme often repeated throughout the high dividend arena is an emphasis on big energy names. Exxon Mobil (XOM) and/or Chevron Corp (CVX) are commonly in the top 10 holdings of these diversified dividend portfolios. According to dividend.com, XOM has a current dividend yield of 3.74%, while CVX yields 5.00%.
As a result of the energy sector woes over the last 12 months, I thought it prudent to look at the overall impact of these stocks on total return. In addition, it should be noted that ETFs with a fundamental or dividend weighting methodology may be increasing their energy exposure in the future to adjust for the higher yields these companies are now paying.
One example of a fund with an outsized allocation to energy stocks is the iShares Core High Dividend ETF (HDV). This ETF is based on the Morningstar Dividend Yield Focus Index, which selects 75 stocks based on their high dividend yields and financial history. HDV currently has $4.3 billion in total assets, a 30-day SEC yield of 3.90%, and an expense ratio of 0.12%.
The top holding in HDV is XOM, which makes up 8.3% of the total portfolio. Energy stocks as a whole are the second largest sector in HDV, with a total weight of 18.45%. Obviously, this is going to result in these energy companies making a big impact on total return and overall yield.
On a year-to-date basis, HDV is down 1.50%, while the broad-based SPDR S&P 500 ETF (SPY) has gained 2.63%. This path of divergence really kicked into high gear over the last two months as the energy sector rolled over once again.
While this overweight exposure has certainly been a drag on HDV, it hasn’t been a catastrophic event because of the counterbalancing effect of consumer staples and health care stocks.
Other well-known dividend ETFs with a relatively healthy dose of energy exposure include:
- Vanguard High Dividend Yield ETF (VYM): ~11.90% energy
- Schwab U.S. Dividend Equity (SCHD): ~11.40% energy
- WisdomTree Equity Income Fund (DHS): ~13.55% energy
- First Trust Morningstar Dividend Leaders Index Fund: (FDL) ~10.62% energy
Investors that believe the carnage in the oil & gas space is due for a bounce may be more inclined to choose a dividend ETF with a higher weighting in this sector. Conversely, those that are less enthusiastic about the prospects for an imminent recovery may choose to underweight or avoid these funds altogether.
I continue to own VYM as a core equity income holding in my Strategic Income portfolio. Despite its flat performance so far this year, the diversified basket of over 430 dividend-paying stocks offers attractive value characteristics and a dependable 30-day SEC yield of 3.26%. In addition, the ultra-low 0.10% expense ratio keeps overall portfolio fees to a minimum.
The Bottom Line
One of the most important exercises that individual investors can do is analyze the index construction of their ETF holdings. Take note of any sectors where your funds are overweight or underweight in order to gauge how they will react under different circumstances. That way, you are prepared in the event that a significant divergence occurs, and you can make adjustments as necessary.
In addition, it’s important to re-evaluate the portfolio on a quarterly or semi-annual basis. These funds undergo regular rebalancing and may shift their exposure based on the mandate of the index provider.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. To get more investor insights from FMD Capital, visit their blog.
