FDRR - FDRR: 3% Dividend Yield But Little Protection Against Rising Rates

2023-03-28 20:53:09 ET

Summary

• FDRR tracks the Fidelity Dividend Index For Rising Rates, a potentially misleading title considering how poor it performed last year.
• My analysis traced the performance to FDRR's sector-neutral strategy and a methodology that places minimal importance on a security's correlation with long-term U.S. Treasury yields.
• DGRO and VYM are more appealing options. They offer a competitive dividend yield and have superior growth, valuation, and earnings momentum metrics.
• FDRR's 0.29% expense ratio and 0.27% median bid-ask spread are additional red flags for traders. I recommend investors avoid this ETF.

Investment Thesis

The Fidelity Dividend ETF for Rising Rates ETF ( FDRR ) is an unnecessary fund for dividend investors, given the significant number of lower-cost alternatives that already offer protection against rising rates. This article illustrates why by comparing FDRR with the iShares Core Dividend Growth ETF ( DGRO ) and the Vanguard High Dividend Yield ETF ( VYM ). By opting for the latter, investors will receive a more diversified portfolio with better downside protection, superior earnings growth and momentum, a lower valuation, and a competitive dividend yield and growth rate. In short, I don't recommend buying FDRR, and I look forward to taking you through the latest numbers next.

FDRR Overview

Strategy Discussion

FDRR tracks the Fidelity Dividend Index for Rising Rates, selecting large- and mid-cap dividend-paying stocks that positively correlate with increasing 10-year U.S. Treasury yields. Selections are expected to grow their dividend payments, and stocks are ranked within each sector according to a score based on the following four factors described in the Index Methodology .

Just 10% is assigned to correlation with U.S. Treasury yields, so the ETF's name could potentially mislead investors. In addition, securities are weighted by market capitalization and selected by their size-adjusted composite scores as follows:

• Sectors with more than 100 securities: select the top 10%
• Sectors with 25-100 securities: select top 20%
• Sectors with less than 25 securities: select all stocks

It's a bit complex, but this step favors low-dividend-paying mega-cap stocks like Apple ( AAPL ) and Microsoft ( MSFT ) because few Technology companies make large dividend payments. It also contradicts FDRR's implied strategy: select companies that perform well as interest rates rise. Technology stocks generally underperform as yields rise because future earnings are converted to present value using a higher discount rate. We saw this last year as FDRR declined by 10.47%. Meanwhile, the iShares Core High Dividend ETF ( HDV ) gained 7.06% because it overweighted Energy stocks, a key driver of high inflation and higher yields.

FDRR's 2.96% trailing yield is relatively high but not uncommon. Other features include up to 10% exposure to non-U.S. developed countries, a 0.29% expense ratio, and $553 million in assets under management. However, FDRR's 0.27% median-bid ask spread is oddly high, so it's not a fund investors should frequently trade. As with any ETF, Authorized Participants and Market Makers work together to ensure the basket of stocks is exchanged at a price close to its net asset value. Still, the large spread is concerning.

Sector Exposures and Top Ten Holdings

The following table highlights sector exposures for the SPDR S&P 500 ETF ( SPY ), DGRO, VYM, and FDRR. As earlier suggested, FDRR's 25.94% Technology exposure is high and different from the average investor's expectations. FDRR takes a sector-neutral approach, whereas DGRO and VYM hold more defensive value-oriented stocks. VYM's 10.33% helped the fund break even last year, and generally, overweighting this sector was the primary reason why many dividend-oriented funds did well. Unfortunately, FDRR did not participate as much.

FDRR's top holdings are below, led by Apple and Microsoft. UnitedHealth Group ( UNH ), Johnson & Johnson ( JNJ ), and Visa ( V ) are the only others with weightings above 2%.

Performance Analysis

Since its August 2016 launch, FDRR gained an annualized 9.83%, or nearly 2% less than DGRO and SPY. FDRR outperformed VYM by 0.86% per year but ironically performed best when interest rates were low. 10Y Treasury yields were between 0.93% and 1.55% in 2021, and FDRR gained 25.30%. When the range increased between 1.63% and 3.88% in 2022, FDRR experienced its worst year since its inception. The sector-neutral strategy and the low 10% weighting to the Treasury yield factor are to blame.

Even if you don't buy FDRR as a way to combat rising interest rates, 26 other dividend ETFs have a better five-year track record through February 2023. Examples include the Schwab U.S. Dividend Equity ETF ( SCHD ), the SPDR S&P Dividend ETF ( SDY ), and the Fidelity High Dividend ETF ( FDVV ).

Another drawback is weak dividend growth. Based on a $10,000 initial investment in January 2017 with reinvested dividends, FDRR shareholders grew their annual portfolio income from $338 to $345 from 2017 to 2022, a mere 2.07% total increase. In contrast, DGRO and VYM shareholders grew their annual portfolio income by 86.59% and 58.57%. Seeking Alpha's Dividend Factor Grades reflect these poor growth numbers, and FDRR earns a poor "C+" Grade overall.

FDRR Analysis

The following table highlights selected fundamental metrics for FDRR's top 25 industries. I also included summary metrics for DGRO and VYM, like in August 2022. After recommending readers instead opt for these funds, the similar returns since demonstrate why you don't always need a complex solution.

Like in August, FDRR has a slightly higher 0.95 five-year beta and trades at a more expensive 18.35x forward earnings valuation than DGRO and VYM. Its 9.32/10 Profitability Score reflects the quality of mega-cap stocks like Apple and Microsoft. Still, analysts aren't bullish on these previous high-growth stocks. Seeking Alpha's EPS Revision Grades reflect consensus Wall Street earnings changes, and they've been trending downward for over a year. High exposure to Technology stocks has not been beneficial, and revision scores today suggest it's prudent to underweight the sector.

Expected growth rates have declined across the board. In August 2022, FDRR's sales and earnings growth rates were 9% and 14%, respectively, about the same as DGRO and VYM. However, they're mid-single-digits today and in a weaker position than these peers. Previously, FDRR also enjoyed a valuation discount relative to VYM, but that's no longer true. A buy recommendation would reflect a hope that Technology stocks will bounce back. Of course, it's possible, but earnings results and trends do not support that view. Yardeni Research reported a 1.1% aggregate earnings per share surprise for large-cap Technology stocks last quarter, matching the S&P 500's figure. Instead, earnings momentum is with defensive sectors more likely held by non-sector-neutral value funds, including DGRO and VYM.

Defensive sectors like Consumer Staples and Health Care are also more stable. Year-over-year earnings growth declined by 0.6% and 3.7%, respectively, compared to a 10.0% decline for Technology. These figures reveal how growth opportunities are drying up. I described this earnings momentum issue in January 2022 in my Invesco QQQ ETF ( QQQ ) analysis. Unfortunately, the problem persists, and I don't see many reasons to return to growth stocks.

Investment Recommendation

FDRR potentially misleads investors into believing it will outperform as interest rates rise. An evaluation of its historical performance and methodology indicates the opposite is closer to reality. FDRR is mainly a sector-neutral large-cap fund with a moderately high 3% dividend yield. Value ETFs like DGRO and VYM do a better job managing downside risk, and since they're cheaper and offer a competitive dividend yield, that's the route I recommend. Thank you for reading, and I look forward to answering your questions in the comments section below.

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