The overlooked risks in dividend-yield ETFs

Focusing too narrowly on dividend-yield strategies could lead to disaster

The overlooked risks in dividend-yield ETFs
In the world of finance, there’s no such thing as a sure bet. Each investment decision comes with a certain degree of risk — and that includes dividend-yield ETFs.

Despite the many benefits investors can derive from dividend payments, focusing too much on dividend yield could be courting disaster, according to a recent article from Morningstar. And by extension, ETFs that focus too much on stocks with attractive dividend yields might be overlooking weaknesses in other areas.

One example noted was the PowerShares High Yield Equity Dividend Achievers ETF (PEY). The fund selects the 50 highest-yield US stocks, weighting them by their trailing 12-month yield. It also attempts to mitigate risk by screening for companies that have raised dividend payments for at least 10 straight years. Following this process, PEY ended up with a financial-sector weighting of 81% in January 2008. At the time of the financial crisis, the greatest proportion of its portfolio was allocated to the most distressed companies, causing it to lose 71.4% from October 2007 through March 2009.

Another issue stems from the fact that dividend yield is a ratio of a company’s dividend payment to its stock price. Therefore, it’s possible for rising dividend yields to occur not because of decreasing stock prices rather than increasing dividends.

This is especially relevant in the case of the energy sector. Plunging oil prices in October 2014 caused the indicated yield from the Energy Select Sector SPDR (XLE) to shoot past that of the SPDR S&P 500.  This was due to a broad freefall in stock price across XLE’s holdings; the fund traded at US$101.26 in June 2014, and it dropped to $85.69 in four months as oil prices tumbled. Investors who didn’t realize this and did not divest themselves from the ETF were exposed as oil companies started cutting dividends shortly thereafter.

Another risk comes from failing to consider dividend sustainability, as was the case for the Global X SuperDividend US ETF (DIV). “Since DIV’s March 2013 inception, its payout ratio, or the ratio of aggregate dividends paid relative to its holdings’ net income, has measured greater than 1.0 times nearly every month,” the Morningstar article said. Firms whose dividends exceed their earnings may be funding the payments with debt, and they could be failing to reinvest appropriately.

“So, while DIV’s average dividend yield of 7.4% looks attractive on the surface, the outlays of many of its holdings don’t seem sustainable,” Morningstar said.

To reduce the chances of exposure to these vulnerable ETFs, Morningstar suggested that investors look for funds that screen for profitability, look for a history of dividend payments, tilt toward firms with higher market capitalization (which implies greater stability), and implement caps to minimize the chances of becoming overweighted toward a single stock or sector.

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