FDRR - FDRR: Strategy Concerns As Interest Rates Decline

2023-12-07 06:28:55 ET

Summary

• Fidelity Dividend ETF for Rising Rates invests in companies expected to perform well in a rising interest rate environment.
• The fund has underperformed historically raising questions about the effectiveness of its strategy with an outlook for rates to decline going forward.
• We recommend investors to avoid FDRR while considering alternative dividend ETFs.

The Fidelity Dividend ETF for Rising Rates ( FDRR ) crossed our radar with its curious fund name. The strategy intended to invest across stocks expected to perform well in a rising interest rate environment faces the question of what happens when rates stop climbing, or even in the scenario of potential Fed rate cuts going forward.

Indeed, the macro setup has shifted over the past year compared to when rising interest rates and concerns of elevated inflation were major market themes going back to 2022. We find that FFDR has underperformed its benchmarks year to date, and also lags historically.

While we believe FFDR can continue generating positive returns alongside the broader market going forward, we're less convinced that the underlying exposure will deliver excess returns over the long run.

What is the FDRR ETF?

FDRR technically tracks the rules-based "Fidelity Dividend Index for Rising Rates". The idea here is to capture exposure to large- and mid-cap companies with a dividend growth profile , focusing on names that have a positive correlation to increasing treasury yields in contrast to high-yield stocks that tend to underperform.

According to the methodology , the top 1,000 U.S. stocks by market value are eligible for inclusion as well as up to 10% of the portfolio allocation to the top 1,000 developed market international stocks.

A scoring system with metrics like dividend yield, payout ratio, dividend growth history, and correlation to rates is used with the top 125 ranked names included through a free-float market cap weighting.

Going through the current portfolio holding 120 stocks as of November 30, 2023, there are not many surprises with familiar names and most mega-cap dividend-paying stocks covered. The largest current holding is Microsoft Corp with an 8.8% weighting followed by Apple ( AAPL ) at 8.6%.

There's nothing necessarily wrong with this positioning, but the appearance here is that FDRR is more or less an iteration of a dividend-focused S&P 500 fund. We find that the sector breakdown is similar to the S&P 500 with FDRR of nearly 30% within Technology sector stocks, essentially maintaining a near-neutral sector exposure.

The metrics that do stand out as different include the more value style with a current dividend yield of 2.9% which is well above the 1.4% yield in the SPDR S&P 500 Trust ETF ( SPY ), but also lower than the 3.6% achieved by the Schwab U.S. Dividend Equity ETF ( SCHD ).

Compared to SPY, FDRR is "missing" the non-dividend paying stocks like Amazon.com ( AMZN ) and Alphabet Inc. ( GOOGL ), while underweighting high-yield names like Verizon Communications Inc. ( VZ ) which plays a more prominent role in the SCHD strategy.

Our main criticism here is that the "rising rates" angle of the fund strategy doesn't stand out. The particular quantitative factor component of selecting stocks that correlate with the 10YR Treasury yield can be described as playing only a small role in the overall fund composition.

FDRR Performance

What's most telling is that FDRR left a lot to be desired precisely during a period defined by "rising rates". During the calendar year 2022 when the 10-Year Treasury climbed from 1.5% to 3.75%, FDRR lost about -10%. While this was a narrower decline compared to the -18% loss in the benchmark S&P 500, FDRR lagged behind alternative dividend ETFs.

At the same time, FDRR's 8% return thus far has helped narrow those spreads, beating out SCHD along with the iShares Core Dividend Growth ETF ( DGRO ) as well as the SPDR S&P Dividend ETF ( SDY ) in 2023.

Our point here is to say that FDRR is fine for what it is as a "dividend ETF" targeting mega-cap stocks, but its actual profile could leave investors with the wrong idea of focusing on the rising rates dynamic.

What's Next For FDRR

The context of the current market environment is defined by what has been a surprisingly favorable cool-off in inflation, even as the economy remains resilient. The understanding is that the Fed may have room to cut rates into 2024 as anchored inflation expectations towards the 2% CPI target would justify such a move.

The 10-year Treasury Yield has already made a convincing move lower from a cycle peak near 5.0% toward a current level under 4.2%.

The good news is that this backdrop should be favorable for equities as an asset class, benefiting from a rebound in the credit growth cycle and stronger earnings expectations. We see FDRR rallying alongside the S&P 500.

It's hard to find a compelling reason to invest in this strategy over alternative ETFs that should perform better with higher exposure to interest rate-sensitive stocks and sectors.

Final Thoughts

FDRR has an interesting concept that could be explored further with some refinements to the strategy. The call we have is that the fund should continue underperforming SPY which we believe has a better-diversified profile that can work through various market cycles.

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