SDY - SDY: 2 Years Later Still A Good Place To Be

2023-09-07 08:57:58 ET

Summary

• The article evaluates the SPDR S&P Dividend ETF as an investment option at its current market price.
• The fund aims to correspond to the total return performance of the S&P High Yield Dividend Aristocrats Index.
• The author has owned the fund for over a decade and believes there is a continued argument for buying.

Main Thesis And Background

The purpose of this article is to evaluate the SPDR S&P Dividend ETF (SDY) as an investment option at its current market price. This fund's objective is "to provide investment results that, before fees and expenses, correspond generally to the total return performance of the S&P High Yield Dividend Aristocrats Index". This includes companies that have increased their dividend for at least 20 consecutive years.

I have written about SDY many times, as I have owned it for over a decade. I generally take a look at it once a year and monitor its progress similarly. With this in mind, I covered the fund exactly two years ago to the day when I placed a consistent "buy" rating on it. Looking back, this was a reasonable call despite all the ups and downs along the way:

As usual, I always take a critical lens to all my portfolio holdings as we near the end of the year. With Q4 about to kick off soon, I thought it made sense to see if SDY deserves more free cash to flow its way. After review, I do see a continued argument for buying - which means my bullish rating should stay in place. I will explain why in detail below.

A Time-Tested Strategy

The primary reason why SDY has been on my radar for years - and will continue to be on my radar - is because of the inherent quality of the underlying holdings. In order to be a dividend "aristocrat" and raise your dividend consistently over time, you need reliable earnings. Of course, you can borrow to pay dividends, but that isn't a sustainable course of action and would be difficult to accomplish over decades. But SDY holds the aristocrats that have proven to know how to grow, increase earnings, and share those earnings with investors. That is a win-win-win in my book.

To understand why, let us look at a simple metric of earnings growth. Since SDY (and the dividend aristocrat index) needs to be able to payout dividends regularly, earnings growth is central to being able to deliver on this objective. By contrast, the S&P 500 is field with more "growth" style names. While these can make up a critical part of an investor's overall portfolio, income is not their primary objective. Many high-flyers in the Tech sector dominant the S&P 500 and are focused on future earnings, not current, and that has a place but not in terms of current dividend production. This is illustrated quite clearly in the short-term when we look at how earnings growth has compared over the past year for these two different indices:

And the results don't just show up in quarterly distributions. The net result of this reality is often out-performance. In fairness, Tech/Growth sectors - and the S&P 500 by extension - will certainly have periods of vast out-performance given their focus. So I see a fund like SDY as a compliment to a broader large-cap market strategy, not a replacement. I would never suggest younger investors avoid growth names - and I own plenty of exposure to that realm myself.

But the opposite is also true that dividend aristocrats can out-perform. It all depends on the economic cycle we are in. And the truth is that when we take out short-term noise or bull markets when investors ignore lack of earnings or valuations, quality names often prevail with better results. In fact, over the past two decades, the dividend aristocrat index has delivered annualized returns that best many other strategies, including a "total stock market" objective (which would be long many growth names):

This ties back to my "time tested" pronouncement. Over the course of years and business cycles, dividend-payers - and especially aristocrats - often win out. If this isn't a reason to have some in my portfolio, then I don't know what is.

Is It Time To Get More Defensive?

I will now dig a little deeper in to SDY specifically. Understanding the make-up and holdings of this fund is critical when determining whether or not an investor would want to buy it. As mentioned above, SDY is light on Tech/growth themes. By contrast, it is fairly heavy in more defensive areas. This is also why it is a good way to diversify, as roughly 40% of its holdings sit in three of the more defensive areas: Utilities, Health Care, and Consumer Staples:

So, the fund has a fair chunk of defensive positioning. But this begs the question: why should we care? And, beyond that, why might we want that exposure now ?

To answer this question, I would point to the broader economic backdrop. The US has avoided a recession after non-stop "recession is coming" headlines and mantra over the past year and a half. Predicting one now seems to be a bit of a fool's errand as the resiliency of the economy and labor market keep preventing it.

But while I would stop short of predicting a recession - or at least a specific time when it will occur - that doesn't mean I don't have macro-concerns about where we are in economic terms. For one thing, growth is slowing, and we need to take that in to consideration. Another is that the Fed is likely to keep rates elevated in to 2024, which could pressure corporate earnings and borrowing capacity. Another important metric to follow is the Fed's balance sheet reduction. This has rattled markets in the past and although it hasn't had much of an impact yet, it still could. This is because the size of the Fed's holding ballooned so much that unwinding it is going to dump trillions of bonds (mostly treasuries and MBS) on to the open market:

All of these items add up to me as an environment where we need to be extra selective with holdings and entry points. Things have been good for a while - and good things never last forever. To this point, getting "defensive" seems like the prudent course of action.

To tie this back again to SDY, let us consider volatility metrics. This is relevant for SDY, but also for many other dividend funds that are out there. So while I like this particular holding and would advocate for it, this is by no means the only option. That said, dividend payers have a sharp advantage when it comes to volatility. Over time, they exhibit much less volatility on a rolling basis compared to their non-dividend paying counterparts:

This is a graph that I believe speaks for itself. Volatility is often lower for dividend payers and that is an attribute that could serve a portfolio well if we are indeed about to enter a more turbulent time. This reaffirms my belief that SDY deserves a place in my holdings list and supports my "buy" rating.

The Index Removes Those Who Can't Keep Up

My final thought touches on why I like the objective of SDY over some other dividend themes. As mentioned, investors have a host of options to choose from when it comes to dividend investing. Of course, you can buy the stocks outright, but with all the ETFs and CEFs to choose from, there are a plethora of ways to play this space.

So why might one want to zero-in on SDY at the expense of these alternatives?

A key reason for me is that the aristocrats index is a difficult one to make and one that is active in the sense of removing those companies that fall short of the dividend requirement even once. So this ensures investors are truly getting the "best of the best" - as opposed to other high yield dividend options that may still hold companies that are under-performing or cutting their dividends. This could occur because the yield could still be "high" in either of those scenarios due to a share price drop. That is not a great dynamic.

This is as relevant of a story today as it ever was. I know this because just the past month we saw an aristocrat announce a dividend reduction. MDU Resources Group (MDU), struggling with earnings, will be cutting its October dividend payout. As swiftly as this announcement was made, the removal of MDU from the index was similarly announced:

What I am trying to convey here is that funds like SDY are not as "passive" as they may suggest in the sense that they are beholden to an index that has very strict criteria. When a company falls outside the requirements of the index, SDY will drop it along with the index. As a "dividend seeker", that is an attribute I view very positively.

Bottom-Line

SDY has long served as a fundamental part of my dividend portfolio, and I don't see that changing. With some economic indicators flashing potential weakness ahead, shifting in to dividend-oriented funds could serve well to provide income and lower portfolio volatility. SDY is one of my preferred funds on this front because of its more restrictive criteria for inclusion and its time-tested strategy of delivering alpha. As a result, I see a "buy" case as still warranted for this fund and suggest readers give the idea some thought at this time.

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