FDL - FDL: More Concentrated Than It Looks And I Like That

Summary

• FDL is a solidly-constructed dividend ETF that is essentially a proponent of the Dividend Aristocrats approach to investing.
• This deceivingly-concentrated ETF (100 stocks, but 25 account for most of the assets) emphasizes companies that have consistently paid dividends.
• I rate FDL a Hold, given the current market climate toward stable stocks versus the go-go tech types. But longer-term, this ETF is always on my radar.

By Rob Isbitts

First Trust Morningstar Dividend Leaders ETF ( FDL ) is one of the more thoughtfully-constructed dividend ETFs an investor will find. It combines the equity research prowess of Morningstar with the concept of "Dividend Aristocrats" to produce a focused, highly-transparent portfolio that delivers a competitive dividend yield. It gets a Hold rating from me. That is primarily because its current portfolio is not geared toward the types of companies that I believe will perform best during this part of the equity market cycle. Thus, it is a solid vehicle whose alpha-producing outlook does not rise to the level of a more positive rating.

Strategy

FDL tracks the Morningstar® Dividend Leaders Index. That index is determined by screening for a combination of high current dividend yield and the ability to pay a dividend year in and year out. Companies with very long annual dividend payment streaks are often referred to as "Dividend Aristocrats."

ETF Grades

• Offense/Defense: Offense

• Segment: Thematic

• Sub-Segment: Dividend Yield

• Risk (vs. S&P 500): Low

Technical Ratings

• Short-Term (next 3 months): D

• Long-Term (next 12 months): D

Rating scale: A = Excellent, B = Good, C = Fair, D = Weak, F = Poor

For a detailed description of MII's proprietary technical rating system, see the Additional Disclosure section of this article.

Holding Analysis

The analysis conducted by Chicago-based research giant Morningstar to run this ETF results in a 100-stock portfolio. However, that portfolio can be significantly skewed, based on that filtering and scoring criteria. So, as is the case currently, many of the 100 stocks can be "along for the ride" in that their weightings are so small, they don't have much of an impact on the over price movement of FDL.

As of this writing, just 25 stocks accounted for 82% of FDL's assets, and the top 10 stocks comprised about 55% of the portfolio. The ETF is heavily focused on Energy and Financial stocks, with the 2 sectors representing over 40% of AUM. Of note is that FDL contains no REITs, allocating instead among the other 10 S&P 500 sectors.

Strengths

FDL has a lot of features I like because to me, they represent what more investors should be looking for in ETFs, but often don't. I am less concerned with how many stocks an ETF owns, and more interested in which ones drive it. And, since many studies of diversification have indicated that alpha potential fades once you get past about 25-30 stocks, I strongly believe that most ETFs are way overdiversified. Or, as the legendary Fidelity fund manager Peter Lynch said, "de-worse-i-fied."

Investors have plenty of choices among dividend ETFs, so I prefer to know what I own. FDL checks that box for me because its fate is driven by a limited number of stocks. I'll discuss the current portfolio below.

FDL has built a strong asset base of over $5 Billion, and trades an average of over $45 Million in volume on a daily basis. That, combined with the Large Cap orientation of the ETF (nearly 80% of assets are considered Large or Mega Cap), provides a liquidity factor that not all dividend ETFs can claim.

Weaknesses

This ETF can be streaky. That's because its systematic approach crowds out market sectors like technology, and REITs. Tech is currently 9% of assets, but in a market that tends to go "risk-on" at a moment's notice, with Tech leading the charge, FDL will likely lag because its Tech weighting is 1/2 to 1/3 of many core stock ETFs. The absence of REITs denies FDL the opportunity to take full advantage of its dividend yield focus, as REITs are among the highest yielders in the large cap stock universe.

Opportunities

There could be a relative stability play to be had in FDL, should the market start to cling to reliable dividend payers. After all, as I like to say, companies can fake earnings, but they can't fake a dividend. They have to pay it in cash. Earnings, on the other hand, can be massaged, manipulated and talked up by company management. All of those factors make dividends a source of stability. The current portfolio sells at only 12x trailing earnings and 1.5x sales, which is reasonable. However, the forward revenue growth is estimated at only a 5% rate, which makes FDL a less-attractive candidate for investors who believe alpha will continue to come from strong earnings growth, as it did for a decade prior to the dawn of the 2022 bear market.

Threats

I like FDL much more on a long-term basis than I do in the short-to-intermediate term. That's because the screening approach currently favors the Energy sector, which I believe is one of the more overextended sectors in the market today. Commodity prices look toppy to me, and that probably makes its way to Energy stock prices. In addition, FDL's 10% allocation to tobacco companies might boost its yield, but that sector does not rank among my favorites, using my technical rating system. Furthermore, this is a stock market that can shun less exciting stocks at a moment's notice. And clearly, that is the nature of FDL's portfolio - these are not the thrilling business on the edge of new growth achievements. They are more value/dividend oriented, and more stable, as evidenced by their prioritizing consistent dividend payments over the decades. So, FDL may be, for a little while, a very not-sexy collection of names, as viewed by the broader market.

The current market climate seems to flirt with stable stocks for weeks at a time, only to run back to the "risk-on" part of the market each time. In other words, bear market rallies, which tend to favor growth stocks, are less friendly to FDL's collection of stalwart businesses. And this is still a bear market for stocks.

Conclusions

ETF Quality Opinion

FDL is unquestionably on my short-list of dividend ETFs. It is a portfolio of 100 stocks that acts more like a 25-stock portfolio. In the years where I managed stock portfolios professionally, I rarely owned more than 30 names. So this ETF looks like a dividend portfolio to me, except for the aforementioned exclusion of REITs.

ETF Investment Opinion

Dividend stocks keep trying to make a comeback, and keep getting cut off by urgent bear market rallies led by FAANG and tech stocks. Investors won't find much of that in FDL, and so while my long-term view of this ETF is positive, I can only muster a Hold rating in the current environment.

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