With the U.S. Federal Reserve (Fed) hiking short-term interest rates for a second time this year, yields across the Treasury curve have increased. Many market strategists continue to expect the Fed to hike at least once more in 2018, which is pressuring many core fixed income strategies.

These moves have also wiped out the premium that existed for U.S. equity dividend yields for the first time since August 2008! In other words, investors who gravitated toward riskier assets like dividend-paying equities to help meet their income needs once again have less-risky options available to them. Furthermore, opting for these less-risky options does not require taking on significant interest-rate risk.

Exhibit 1: Short Government Yields Now Pay More Income Than the Broad Market and Dividend Growers

Rising Rates Are Hurting Most Dividend ETFs

Rate hikes have led to the underperformance of classic bond proxies. The consumer staples and telecommunication sectors have been hit the hardest, and are down 12.49% and 10.48%, respectively, year-to-date (YTD) through May 30.1 This has brought down the majority of dividend indices. In fact, 84% of U.S. equity ETFs with a trailing 12-month dividend yield greater than the S&P 500 Index are underperforming the broader market through the first five months of 2018. Those ETFs represent a whopping $375 billion in assets under management and the majority of the largest dividend funds.

Exhibit 2: Few Dividend ETFs are Outperforming the Market YTD

 

Number of Funds

Assets Under Management ($B)

Outperforming1436.44
Underperforming76375.35

Source: Morningstar, as of 05/18.

This performance highlights the acute challenge that investors face when it comes to allocating assets in the face of rising rates. Should investors simply abandon dividend ETFs? We would argue against that strategy. Instead, we would suggest that investors continue to build multi-asset income solutions, but also evaluate what’s under the hood of their ETFs, because not all dividend strategies are alike.

To illustrate this point and understand what dividend opportunities the market is rewarding today, we reviewed the characteristics of three dividend investment approaches, one of which is outperforming the market today and two of which are underperforming. Dividend growth and dividend yield are two common approaches to dividend investing. Dividend growers focus on companies that can grow their dividends over time, while dividend yielders look for companies with the highest dividend potential. The third approach – embodied by Oppenheimer Ultra Dividend Revenue ETF (RDIV) – targets high-dividend-paying stocks, then weights them by revenue rather than dividend yield or growth. This approach tends to emphasize companies with attractive fundamentals within the high-dividend space.

Comparing Dividend Investing Approaches

We began by comparing the three approaches through the lens of valuations and yields. Dividend growers may offer a cheaper entry point than the market, but the increase in yield over the index is barely noticeable, and both are similarly challenged today by rising risk-free rates. Meanwhile, most dividend yielders offer noticeably higher income compared to the broad market, but these stocks trade richly, with a valuation nearing two times the price-to-sales (P/S) ratio. The basket that is outperforming the market, represented below by RDIV, enjoys an outsized yield and a low P/S ratio entry point.

Exhibit 3: RDIV Offers a Strong Combination of Low Valuations and High Yields

We next look at market capitalization. Small caps have underperformed the past few years, but amid global trade war fears, investors have bid up this growing valuation discount relative to large caps YTD. Dividend indexes that have flexibility inherent in their methodology to move down market cap have outperformed this year, as shown by RDIV’s lower market cap ($17 billion average market cap) compared to dividend growers ($58 billion) or dividend yielders ($94 billion). When we look back at the group of U.S. dividend-paying equity ETFs that have outperformed this year, we see that the average market cap is one-third of the average market cap of the underperforming group of ETFs.

Exhibit 4: RDIVs Methodology Allows Flexibility to Go Down Market Cap, Helping Performance YTD

Finally, we considered the impact of rising borrowing costs on income investments. When interest rates rise, companies pay higher interest costs on future debt issuances, and equity prices fall as investors discount these now higher costs. This effect is more pronounced within the dividend segment of the market, as these companies are more likely to fund their operations with debt issuances. However, these same companies have the potential to offer an embedded “cushion” to investors. In a similar vein to the well-documented concept that high-yield fixed income outperforms in rising-rate environments, this equity dividend component offers a steady return to shareholders during more uncertain times, while historical price appreciation return is more unknown, especially in today’s environment when equity valuations are relatively stretched.

Exhibit 5: Rising Rates May Leave Income Strategies Without a Sizable Dividend Cushion Variable

In closing, the decade-long “yields-are-compressing” story that retirees have heard time and again has quickly changed. Investors now enjoy government bond yields that exceed the broad market and even some dividend-grower index yields. With this changing story comes an investor need to get more creative within dividend equities to earn an above-market income while being compensated for additional equity-like volatility, and as noted, we are seeing these thematic shifts play out within returns this year. Through its methodology, the S&P Ultra Dividend Revenue ETF can provide value within an income allocation even as risk-free rates surge.

 
  1. ^Source: Bloomberg Finance, L.P., as of 05/18.