SDY: Flawed Holding Strategy Resulting In Underperformance

seekingalpha06-02

Richard Drury Overview We are living in one of the best times to be an investor. There is an abundance of ETFs that follow whatever strategy you want. When it comes to dividend-based ETFs, there are a...

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There is an abundance of ETFs that follow whatever strategy you want. 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There is an abundance of ETFs that follow whatever strategy you want. When it comes to dividend-based ETFs, there are a ton with varying strategies and holdings. Today I wanted to discuss State Street Global Advisors' ETF, SPDR S&P Dividend ETF (NYSEARCA:SDY). SDY gives you instant exposure to some of the best dividend paying companies in the world. However, the ETF has severely underperformed peer dividend ETFs over most time periods. So even though SDY gets the job done, there are some clear vulnerabilities that I want to discuss. I often look for dividend ETFs that can serve as a compliment to my portfolio of individual holdings. Dividend ETFs can be a nice channel for cash when there are no current deals in the market on individual holdings. Data by YCharts SDY has a reasonable expense ratio of 0.35% and about $20B in AUM (assets under management). The fund's inception dates back to 2005. The ETF has a stated objective to provide investment results that generally aligns with the S&P high-yield dividend aristocrats index. The fund filters for companies that have paid out dividends for at least 20 consecutive years. While this increases the likelihood that dividend growth can be sustained, it may limit exposure to companies that growth at a faster rate since they are using excess capital to prioritize dividends rather than reinvest in their business. In addition, the current dividend yield sits at 2.5% and the dividend has grown at a solid rate over the last decade. While the upfront starting yield is very low, the dividend growth enables a compounding effect to happen. With a long-term outlook, it's entirely possible to create a sizeable dividend income stream with SDY. However, I think there may be better alternatives dividend ETFs out there that can deliver both better dividend income growth as well as a higher total return through greater levels of capital appreciation. Holdings There are roughly 135 individual holdings within the ETF and they have all paid dividends for at least 20 consecutive years in a row. While this strategy probably has the best intentions in mind, it doesn't actually serve very useful in practice. Just because a company has achieved over 20 years of dividend payments, doesn't mean that they are good quality companies. Taking a look at the top ten holdings, we can see a mix of companies throughout different industries. SDY has a primary focus on industrials, accounting for 20% of the total weighting. This is closely followed by consumer staples and utilities which both make up approximately 17% each. While these sectors may highlight a sense of security because of the defensive nature, I believe this leaves a major vulnerability that causes less growth to be captured. We can see that the fund also includes exposure to real estate, which further adds to this problem since real estate has been the worst performing asset class since interest rates rapidly rose to new decade heights. State Street Additionally, SDY lacks any meaningful exposure to the tech sector. While this can be expected since tech companies aren't typically known for their dividend yields, this lack of exposure means that the ETF has a lesser amount of companies that have 'growthier' characteristics. Taking a look at the top ten holdings, we can see that 3M (MMM), Realty Income (O), and Southern Co (SO) are the largest holdings within. While no individual holding accounts for more than 3% of the weight, these holdings have performed poorly over the last few years.   Company Weight %   3M 2.69%   Realty Income 2.47%   Southern Co 1.86%   Chevron Corp 1.80%   Xcel Energy 1.79%   Edison International 1.79%   T Rowe Price Group 1.76%   NextEra Energy 1.70%   Kenvue Inc 1.64%   Consolidated Edison 1.63%   Click to enlarge For reference, here is the performance of the top three holdings and SDY. While Southern has performed quite well, 3M and Realty Income have both been negative over the last five-year time frame. 3M has been going through a slew of ongoing litigations one after another and the dividend has been the only appealing aspect of the company as growth has lagged. Realty Income has been suppressed in valuation because of the higher interest environment that we remain in. Higher interest rates make it less affordable to acquire new debt to fuel expansions and acquisitions. Higher interest rates also directly translate to higher interest payments on any debt held. Therefore, the real estate sector as a whole has been held down since rates started rising in 2022. Data by YCharts Vulnerabilities I believe that the top sectors SDY is exposed to remain highly vulnerable to macroeconomic conditions. Things such as high-interest rates, higher than anticipated levels of inflation, and shifting consumer spend to name a few. Industrials, consume staples, and utilities have all been impacted by the higher interest rates especially. Taking a look at SDY's price in relation to the federal funds rate, we can see that the price of SDY started to move upward quickly when rates were cut to near zero levels in 2020. Conversely, one rates started to rapid rise the price of SDY sort of stabilized at the current levels and traded sideways ever since. Data by YCharts Believe it or not, these higher interest rates can have ripple effects throughout these industries in its own unique way. For example, industrials rely on cheap debt financing to fund operational growth and other capital expenditures. Higher rates make it less attractive to acquire new debt and the result could be projects or new developments having their timelines delayed to future dates. The same thing applies to companies within the utilities sector as well. Utilities are generally known for their higher dividend yields but when interest rates rise, fixed income investments may become more appealing. This causes a shift of investor capital to get withdrawn from the sector and allocated to areas that may be less risky. Why settle for a 4% dividend yield on a utility stock that may decrease in value when you have the ability to get the same yield from a CD (certificate of deposit) or even a savings account? Lastly, higher interest rates can cause an increase in the cost of goods for consumer staples. Raw materials may increase in price which causes the operating profit margins to be lower for consumer-based companies. In turn, they pass these costs along to the customers through price increases where possible. While this may offset the cost of goods, this may also cause customers to spend less money and tighten their budgets. Customers may opt for cheaper alternatives or completely lower spending levels altogether. Dividend As of the latest declared quarterly dividend of $0.7079 per share, the current dividend yield sits at 2.5%. While the dividend yield has been quite low, the dividend growth has been sufficient enough to see a growing dividend income over time. Over the last decade, the dividend has increased at a CAGR (compound annual growth rate) of 7%. However, the dividend has recently increased at a much lower rate since the holdings within remain a bit vulnerable to interest rate changes. For reference, the dividend has increased at a small CAGR of 1.36% over the last 3-year period. Seeking Alpha In addition, the dividend history hasn't been the most stable in terms of consistency. While SDY has provided 16 years of consecutive payouts, it has only provided 1 year of consecutive growth. The dividend has a history of getting reduced based on the fund's performance. Taking a look at the dividend history chart, we can see that there has been moments of high payouts because of special dividends, but also a very weak growth trajectory overall. I believe that the only way to really see any sizeable dividend growth from SDY would be to essentially create your own growth. You can see this by reinvesting all dividends received alongside dollar cost averaging into this ETF every single month. To test this out, I ran a back test calculation using Portfolio Visualizer. This calculation assumes an original investment of $10,000 at the start of 2015. It also assumes that you contributed $250 per month throughout the holding period while also reinvesting all dividends. Portfolio Visualizer In 2015, the dividend income received would have totaled $726. Fast forwarding to 2023, your new dividend income would have totaled $1,662. This means with consistent contributions and dividends reinvested, your dividend income would have doubled over the course of about nine years. One of the downfalls of this fund, however, is that the distributions received may be partially considered as ordinary dividends because of the inclusion of real estate. These ordinary dividends are treated with less favorable tax consequences than qualified dividends. Performance Comparison & Valuation The most popular dividend ETF out there is probably Schwab's Dividend Equity ETF (SCHD) and my personal favorite dividend ETF is Fidelity's High Dividend ETF (FDVV). I think these would be great comparisons because they both pursue a similar goal while varying in strategies. These differences would be a great opportunity to highlight the shortcomings of SDY. Starting off, we can see that FDVV has provided the highest total return over the last five years. Data by YCharts I believe that this can be sourced back to the difference in holdings and strategy. FDVV has a primary weighting towards the tech sector that sits at 23.06% of the total value. This is extraordinary when compared against SCHD's exposure of 8.7% and SDY's weight of only 6.6%. This has helped FDVV achieve a higher level of growth since these tech companies typically trade at high valuations and invest more capital back into their businesses to fuel growth, rather than distributing it out as a dividend. I recently put together an article that explains why I prefer FDVV over SCHD. Speaking of dividend, FDVV manages to maintain tech exposure while also providing a higher yield than SDY. SCHD's dividend sits at 3.4% while SDY's dividend is only 2.5%. SCHD is the clear winner in terms of dividend growth here with a dividend CAGR of 10.87% over the last decade and 12 years of consecutive dividend growth. SCHD's dividend growth is likely to provide a superior income growth over a long period of time because of its emphasis on companies that have strong dividend growth potential, rather than using SDY's strategy of focusing on companies with 20 years of payouts. Just because a company has managed to pay out dividends for over 20 consecutive years does not mean that their growth can be sustained going forward. Data by YCharts With these in mind, my final take is that FDVV has the potential to provide a superior total return through the likeliness of more capital appreciation captured from its tech exposure. On the other hand, SCHD can provide a super dividend income growth over time as the fund's strategy is to focus on filtering for companies with strong dividend growth futures. SDY's priority of focusing on the history of dividend payouts rather than future growth potential makes it a less appealing choice that will likely result in underperformance. While the price of SDY sits near all-time highs, it has traded sideways for about 3 years now. This is likely due to the vulnerability of higher interest rates that are effecting the top sectors within SDY. When the time comes for interest rates to get cut, we may finally see some upside as macroeconomic conditions improve. However, when we consider the fact that the presidential election is coming up and the labor market still remains strong, I wouldn't bet on interest rates being that strong. The presidential election already adds a layer of uncertainty in the market. The Fed would likely avoid changing rates too drastically because this would only add to the uncertainty. Therefore, I believe we'd get a very slight cut in rates by (25bps). Historical data shows us that the Fed has raised or cut rates over the last five election years. However, we've seen what dramatic rate cuts can do to the market volatility based on what happened in 2020. Additionally, the labor market still remains strong with the unemployment rate below 4%. As the Fed waits for more economic data to roll in, I don't believe there is enough of an incentive for large rate cuts at this moment. Even in a case where interest rates are hiked once more, we may actually see the price of SDY come down a bit due to the increased pressure from the top sectors. SDY current trades at a price to earnings ratio of 20.69x. For reference, SCHD trades at a price to earnings ratio of 15.92x and FDVV trades at a price to earnings of 17.02x. This means that SDY trades at a higher premium than its peers while also offering a lower performance history. Therefore, I am rating SDY as a sell. Conversely, if interest rates get cut by the end of the year, this may increase valuations. This would make it more affordable for companies to acquire debt that can be allocated toward different growth initiatives. Additionally, lower interest rates may cause cost margins to improve and the cost of goods to drop in price. This would ultimately increase the profit margins across the board for most sectors. The consumer staples sector would also likely see a buff in earnings potential due to increased consumer spend when rates come down. There, if rates come down, I can see SDY moving up in price and closer the performance gap against some peers. Takeaway  SDY is another dividend ETF that offers exposure to some of the most reliable dividend paying companies in the world. However, I believe the strategy of focusing on dividend companies with 20 years of established history is flawed. Just because a company has managed to pay a dividend for over 20 years does not make it an ideal investment going forward. We can see the proof of this when comparing the performance of SCHD against SDY, as SCHD prioritizes the potential growth opportunity of the dividend by looking at companies with growing levels of free cash flow. Likewise, the sector and holding allocations of SDY are flawed due to the higher exposure to industries that are vulnerable to interest rate fluctuations. Additionally, SDY lacks tech exposure to support any potential future growth the way that FDVV does.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.24.2","shortVersion":"4.24.2","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2440129654"}