4 Dividend ETFs To Avoid If You Expect An Earnings Recession
These ETFs score comparatively poorly on profitability quality and could get hit harder than average in a downturn.
With the Q1 earnings season kicking off in earnest this past week, the markets could focus less on the Fed & interest rates and more on the fundamentals that actually matter. This will be a particularly interesting to see not how companies fared in the 1st quarter of the year, but how they expect to perform for the remainder of 2023. Companies, including Walmart and Target, have already warned about consumer weakness and multiple manufacturing names have expressed that conditions are slowing.
Wall Street still seems overly optimistic about earnings going forward. The current analyst consensus calls for 1% earnings growth in 2023 and 12% growth in 2024. Not exactly the kind of forecast you’d expect with most signs pointing towards recession in the next 6-12 months. There’s a very reasonable chance that forward earnings forecasts continue getting revised lower as the year progresses and that could pull the equity markets down with it.
That could put the emphasis on ETFs that focus on high quality dividend stocks, strong balance sheets and healthy cash flows. Those themes played out well in 2022, but have taken a back seat in 2023 as investors talk themselves into the strong economy narrative. In reality, jobless claims are rising, the manufacturing sector is contracting and new single-family home construction is plunging. All of these are leading indicators of a recession with a nearly perfect track record.
Not all dividend ETFs, however, have the best fundamental profile. Those that focus less on balance sheet quality and more on factors, such as yield, are at higher risk of underperforming during market downturns. Using Portfolio Visualizer, I ran a regression analysis on the most popular dividend ETFs to identify which factors most heavily influenced returns.
In particular, I looked at the profitability factor “RMW”, which stands for “robust minus weak”. In short, higher is better. These are the companies that have better earnings/profit profiles and could, in theory, hold up better in a bear market.
Conversely, the ones that score lowly are the ones to consider avoiding if you think that earnings are about to degrade. Let’s run down the 4 dividend ETFs that come up short on the profitability factor.
SPDR Portfolio S&P 500 High Dividend ETF (SPYD)
It’s not surprising that this ETF got flagged. Its selection criteria simply targets the 80 highest yielding stocks within the S&P 500 and equal-weights them. There’s no screening criteria that includes only positive earnings growth, cash flows, low debt, low payout ratios or anything else. It’s just purely yield.
Pure yield strategies allow for the inclusion of companies whose stocks may only have artificially high yields because of a significant price decline. They may hold stocks that are at risk of a dividend cut. You can find some ETFs that exclude the top 10% of yields, for example, in order to minimize that risk, but SPYD isn’t one of them. This fund is much cheaper than the S&P 500, but the portfolio also produces much lower net margins, ROE and return on invested capital.
iShares Select Dividend ETF (DVY)
DVY is a relatively concentrated portfolio of 100 dividend stocks that are weighted by their dividend yield. This ETF does attempt to apply a few quality screens as well, but it only provides modest benefits.
In order to qualify, stocks must have a dividend per share higher than its 5-year average, a dividend coverage ratio of at least 167%, a 5-year history of paying dividends and a non-negative trailing 12 month earnings per share. Those criteria help to ensure some dividend sustainability and weed out some of the really bad actors, but they’re not terribly strict and don’t do a lot to meaningfully improve the quality component of the fund.
Vanguard High Dividend Yield ETF (VYM)
You’re probably starting to sense a theme with the high dividend yield ETFs. In the dividend ETF draft article I wrote several months back, I didn’t even have VYM in my top 14 picks. The reason was simple - weak selection criteria. VYM simply ranks all qualifying components of a broad market index by forecasted dividend yield and takes the top 50% by market cap.
VYM accomplishes the goal of delivering an above average dividend yield, but 1) it pretty much only looks at dividend yield like SPYD and 2) is very loose with how many stocks make it in the portfolio. At least SPYD only includes about 15% of the S&P 500. VYM includes a full 50% of the total equity market capitalization.
Therefore, it shouldn’t be too surprising that VYM generated the worst profitability rating of the dozen dividend ETFs I looked at in this exercise.
iShares Core High Dividend ETF (HDV)
And another high yield ETF! HDV also targets a relatively small subset of the broad stock market universe - just 75 names - but it also uses a pair of Morningstar screens to add a financial health component. Qualifying stocks must have a Morningstar Economic Moat rating of “narrow” or “wide” and a Morningstar Distance to Default score in the top 50% of eligible dividend-paying securities. Both of these are a little amorphous for my liking and I’m not sure they do a whole lot to help to improve portfolio quality.
Most companies are probably very distant to defaulting anyway, especially in this era of mountainous government debt, huge liquidity stockpiles and a willingness by the Fed to backstop nearly any financial problem. So this metric is probably a non-factor. The economic moat is a little more interesting, but it’s also pretty subjective.
We can nitpick the investment strategies all day, but the point is that there are better dividend ETFs available out there if you’re looking for portfolio protection in a down market. Ones that use very specific balance sheet related criteria, such as the Schwab U.S. Dividend Equity ETF (SCHD), would be much more preferable.
ETFs in Focus
Here’s a look at the weekly net flows/RSI matrix, where I try to get a sense of what the markets are doing relative to what investors are doing to see if there are disconnects.
Note: Most ETFs will fall above the 0% flows/AUM line because, well, ETFs take in hundreds of billions of dollar annually. So I’m looking at 1-month flows to focus on the short-term (1-week flows are too choppy to have high confidence in the results). Upper-left quadrant would identify ETFs that are performing poorly but are seeing investor money moving in. The lower-right quadrant would be ETFs that are performing well, but seeing money leaving. Both could provide contrarian opportunities. I wouldn’t call them buys or sells. Just more of a way of potentially identifying trends.
Communication services (XLC) and junk bonds (HYG) appear to be getting a lot of attention from investors in recent weeks. Communication services has been the best performing sector of 2023 so far (after a miserable 2022) and junk bonds continue to hold up very well despite some deteriorating economic fundamentals in the background. Momentum (MTUM) continues to see considerable outflows, but it’s also heavily allocated to energy and healthcare. Both sectors have done particularly well over the past few weeks and could soon see money flowing back in.
The exuberance around Treasuries appears to have subsided for the time being. T-bill (SHY) net flows have turned neutral again after strong months in both February and March. Long-term Treasury ETFs (TLT), however, have continued to see steady monthly inflows despite hitting a bit of a rough patch in recent weeks.
Instagram Post of the Week
Recently, I put up a post detailing the best performing dividend ETFs from the 1st quarter. If you’re looking for the biggest and most popular funds, you’re going to be disappointed. The ones with double digits gains were mostly focused on international stocks, including those hedged against currency fluctuations. The only U.S. focused ETFs came from the tech sector - the First Trust Nasdaq Technology Dividend Index ETF (TDIV) and the ProShares S&P 500 Technology Dividend Aristocrats ETF (TDV).
Overbought & Oversold
Overbought: SLV, EIDO, NGE, EWL, EDEN, IEUR, GCOW, ECOW, WGMI, GXG
Near Overbought: DBA, BLOK, USO, GDX, XLV, XLC, OEF, EWZ, EWC, EZU, EWI, EPOL, EWU, MGC, VDC, BITO, RPG
Near Oversold: KRE, MSOS
Oversold: CYA
Note: Oversold/Overbought developed using a combination of RSI and Longbow dashboard.
A brief note…
I’m on Instagram now! You can click HERE to follow. It’s a spot where I’m going to be dropping more infographics, stats and visual content. I think you’ll find it useful for more “quick hits” on the latest trends and ideas!
Hope you’ll join me!