Some Dividend ETFs Will Fare Better Than Others As Interest Rates Rise

ETF investors, take note. The word on the street is that a Donald Trump presidency could hasten the end to an era of historically low interest rates. During his campaign, the president-elect rumbled that low rates hurt American savers and distort the market.

So far, stock market investors have taken a Trump win in stride. Fears of market volatility if he won have not been realized. So a rate hike by the Fed next month is still seen to be in the cards. Beyond December, rates are likely to keep edging up. And if Trump's economic agenda drives up inflation, rates could rise more quickly.

What does that mean for yield-hungry investors who flocked to exchange traded funds offering dividend income this year?

Rising interest rates could be a headwind for income equities. Investors may dump their dividend stocks for less risky income assets, such as bonds, in such a climate. But rising rates don't weaken the case for all dividend-paying stocks, according to investment management firm BlackRock.

"We prefer dividend growers over dividend payers in the environment of gradually rising interest rates we see ahead," Richard Turnill, BlackRock's global chief investment strategist, wrote in a Nov. 7 note. "High-yielding dividend stocks typically suffer more when rates rise than dividend growers - quality companies with enough free cash flow to sustain dividend increases over time."

Popular ETFs that investors use to target dividend growers include Vanguard Dividend Appreciation ( VIG ), Schwab U.S. Dividend Equity ( SCHD ), iShares Select Dividend ( DVY ) and SPDR S&P Dividend ( SDY ).

All these funds own companies with long histories of increasing dividends. Their holdings include the likes of Microsoft ( MSFT ), McDonald's (MCD), AT&T (T) and Chevron (CVX), which have raised payouts from 10 to 20 consecutive years.

Sector Focus

The potential for a December rate hike will impact dividend ETFs differently, depending on their sector exposure, said Todd Rosenbluth, director of funds research at CFRA.

"Higher-yielding sectors - such as consumer staples, telecom and utilities - would be more negatively impacted by a rate hike, while consumer discretionary, financials and technology should do better," he added.

Rosenbluth recently studied the exposure of dividend ETFs to a particular high-yielding sector: real estate.

With the recent elevation of real estate as a stand-alone S&P sector, "investors now have greater transparency about the exposure they have to these income-oriented equities," he said.

Although real estate companies are virtually synonymous with dividend investments, some dividend funds shut them out, Rosenbluth found. Others have big helpings in the sector. Even among dividend growth funds, sector exposures vary widely depending on the methods used to select and weight stocks.

  • Vanguard Dividend Appreciation, with $21.85 billion in assets, has no real estate holdings. Its biggest sector weighting is consumer staples, at 23%. The ETF has a 12-month yield of 2.09%.
  • iShares Select Dividend, with $16.17 billion in assets, also has zero real estate exposure. It has a 30% weighting in utilities, the biggest sector tilt. DVY yields 3.20%.
  • SPDR S&P Dividend, with $14.37 billion in assets, has 9% of its assets invested in real estate, higher than the S&P 500's 2.3% weighting in the sector. SDY's largest sector weighting is industrials, at 16%. The ETF yields 2.40%.

DVY has gained 15.3% in 2016 through Oct. 9 vs. 14.9 for SDY and 9.2% for VIG.

By comparison, SPDR S&P 500 (SPY), a proxy for the broad U.S. market, is up 7.8% and yields 2.08%.

Investors poured roughly $3 billion into VIG, DVY and SDY combined year-to-date through October.

Dividend income will account for a larger part of investors' more modest portfolio returns over the next five years, according to BlackRock.

"Bond yields have likely bottomed out, and we don't see scope for big rises in already elevated stock market valuations amid tepid earnings growth," Turnill wrote.

The new Fidelity Dividend ETF For Rising Rates (FDRR) selects stocks based on correlations to increasing 10-year U.S. Treasury yields.


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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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