While there’s nothing enjoyable about experiencing a market correction, it can sometimes provide just the jolt we need to get our portfolios back on the right track. Sure, owning high tech stocks when they’re returning more than 30% in 2017 with almost no volatility to speak of is great while you can enjoy it, but things can get a little nasty when the market turns. The S&P 500 (SPY) is still around 7% off of its all-time highs, but the ROBO Global Robotics And Automation Index ETF (ROBO), one of 2017’s top performers, is still more than 12% off of its highs. If you’re one of those folks who rode the momentum wave to big gains in 2017, your portfolio might now be a little out of whack.
There’s never a bad time to add a quality dividend ETF to your portfolio, but now may be an especially good time. With growth and momentum stocks delivering such strong returns at almost no additional risk, many dividend stocks have found themselves getting left behind. The upside is that the market correction has pushed the valuations on many of these cash-rich companies back down to more appealing levels. Plus, corporate tax cuts will begin showing up in first-quarter financial statements, which could lead to companies making a big push to increase dividends and share buybacks. Add those catalysts together, and you’ve got a formula that could deliver above-average returns for dividend payers in 2018.
ETFs targeting higher equity yields have lagged considerably since the start of 2017, but funds invested in long-term dividend growers have by and large done pretty well. One of those funds targeting dividend growth companies, the Vanguard Dividend Appreciation ETF (NYSEARCA:VIG), could do particularly well in 2018.
A Primer on VIG
VIG follows a modified market cap-weighted index that targets companies which have increased their regular annual dividend payments for at least 10 consecutive years. While VIG doesn’t qualify as a “Dividend Aristocrat only” fund (companies need a track record of at least 25 years of growth to earn that title), many of its components are. In fact, the fund’s top 30 holdings, which comprise roughly ⅔ of its total assets, average more than 27 consecutive years of dividend increases.
VIG’s top 10 holdings include some of the economy’s biggest cash generators. In almost every case, the company generates more than double the amount of free cash flow as it pays out in total dividends. It’s also a nice diversification tool when paired with the S&P 500, since it more than doubles the total weighting to the more conservative industrials and consumer staples sectors, while paring back allocations to tech and financials. Only 18% of VIG’s assets overlap with the S&P 500.
A Dividend Growth Machine
With VIG, you’re not necessarily going to get a high dividend yield, but what you will get is a portfolio of companies that will continually give you a pay raise. To illustrate, I’ve used the U.S. Dividend Champions dataset from the DRIP Investing Resource Center website. I’d highly recommend this site if you’re someone who researches their own dividend growth opportunities (and the site actually includes dividend history data for companies with as little as five years of annual growth). As a baseline, I looked at VIG’s top 30 holdings. This number represents around ⅔ of the fund’s assets, and since the fund has nearly 200 holdings, it made it a little impractical to plug all of them into my calculations. Still, this should provide a good proxy for the fund as a whole.
Let’s take a look at each of VIG’s top holdings, along with their dividend track records.
As mentioned earlier, the top 30 holdings have a weighted average of over 28 years of consecutive dividend growth. VIG has had a dividend yield right around the 2% mark for much of the last decade, a number right in line with the S&P 500, and should be expected to carry that rate forward into the future. That yield may seem disappointing compared to the 2.55% simple average yield of the dividend grower universe, but keep in mind that this universe is skewed higher by the presence of REITs and MLPs, two groups that the fund doesn’t own. You can also notice that the VIG top 30 has a history of delivering double-digit dividend hikes all the way back to the dot-com bubble, even though the graphic above doesn’t go that far back.
Risk and volatility measures also demonstrate VIG’s history of delivering superior risk-adjusted returns.
Over the past 10 years, VIG has narrowly underperformed the S&P 500, but has done so while taking on about 15% less risk. That performance is reflected in its higher Alpha, Sharpe and Treynor Ratio measures.
Conclusion
With 2016’s near-zero interest rate environment, investors looked to equity dividends of any kind for income. With at least 3 rate hikes on the horizon, and equity dividends looking less appealing relative to higher expected fixed-income rates, I’d expect investors to be a little more particular in their dividend stocks and go with dividend growers over high yielders. I have some concerns over the fund’s smaller allocation to financials and avoidance of energy companies, two areas of the market that I think could do well in 2018. I also wonder if this rising interest rate environment (10-year Treasury yields just hit 4-year highs) might stifle the potential growth of equities going forward.
But long-term dividend growers have a history of standing up to less-than-favorable economic conditions and managing to outperform the broader market. Given interest rate forecasts and inflation, which is starting to show signs of increasing, investors would be well-served sticking to the tried and true, cash-rich dividend payers. VIG is just the place that you’ll find them!
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Dave Dierking, CFA
Editor of ETF Focus on TheStreet.com. On Substack at www.substack.com/etffocus. To receive notifications of new articles and blog posts as soon as they're published, click on the orange Follow button and become a real-time follower.
Analyst’s Disclosure: I am/we are long VIG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
