DJD - SPHD: 14 Substitutions Made High Yield Remains But What's Next?

Summary

• SPHD tracks the S&P 500 High Dividend Low Volatility Index. It has a 0.30% expense ratio, $4 billion in assets, and reconstitutes twice annually to ensure key objectives are achieved.
• The last reconstitution deleted 14 companies primarily due to recent strong performance, driving down dividend yields. Shareholders should net 4.26%, and the portfolio's 0.85 five-year beta was unchanged.
• Unfortunately, the 14 additions included several stocks with poor earnings momentum, as indicated by Seeking Alpha's EPS Revision Grades. SPHD faces an uphill battle against Wall Street analysts.
• Furthermore, SPHD's 5.25% long-term dividend growth rate isn't supported by sales and earnings growth estimates. It remains a low-growth portfolio that's best viewed as a pure income play.

Investment Thesis

Designing an income-producing portfolio that limits losses during market crashes is an admirable goal that makes sense for investors in or near retirement. You may have come across the Invesco S&P 500 High Dividend Low Volatility ETF ( SPHD ), which satisfies two key investment objectives. This 50-stock fund holds S&P 500 companies screened for high dividends with the most volatile ones removed, and the Index recently substituted 14 stocks as part of its semi-annual reconstitution process. After analyzing the portfolio pre- and post-reconstitution, I'm pleased to report that SPHD's yield and volatility features remain strong.

However, SPHD's share price is at a higher risk today because the Index added securities with poor earnings momentum. It's a contrarian play that might work out. But it's not wise to bet against Wall Street with such a short six-month period before the next rebalancing. Furthermore, SPHD's sales, earnings, and dividend growth rates are too low, and its valuation isn't great compared to its peers. Therefore, I don't recommend investors buy SPHD, and I look forward to explaining why in further detail below.

SPHD Overview

Strategy Discussion

SPHD tracks the S&P 500 Low Volatility High Dividend Index and comprises 50 S&P 500 Index securities. The selection process identifies the top 75 securities by yield and removes the 25 most volatile ones based on price volatility over the last year. Therefore, securing a high dividend yield is the Index's primary objective, while low volatility is secondary. The Index is yield-weighted and has security weights between 0.5% and 3.0% at each rebalancing date. Reconstitutions occur semi-annually at the end of January and July, and no more than ten securities are allowed per sector.

SPHD has a 4.56% gross indicated dividend yield and a 0.85 five-year beta. The Global X Super Dividend U.S. ETF ( DIV ) and the Invesco High Yield Equity Dividend Achievers ETF ( PEY ) are the only peers with gross dividend yields above 4.00% and five-year betas below 0.90. If you relax the yield minimum to 3.50%, the following peers may interest you.

• iShares Core High Dividend ETF ( HDV )
• iShares Select Dividend ETF ( DVY )
• VictoryShares US EQ Income Enhanced Volatility Wtd ETF ( CDC )
• VictoryShares US Large Cap High Div Volatility Wtd ETF ( CDL )
• Dow Jones Industrial Average Dividend ETF ( DJD )
• VanEck Morningstar Durable Dividend ETF ( DURA )
• Franklin Low Volatility High Dividend ETF ( LVHD )

Performance Analysis

The following table highlights the total returns through January 2023 for the ten funds mentioned, including SPHD. I've sorted them by five-year returns, and all but DURA have at least that track record.

SPHD's 30.98% gain since February 2018 was about 7% and 13% less than HDV and PEY. Portfolio Visualizer provides some additional statistics on risk and return.

Since its inception, SPHD gained an annualized 9.82% compared to 9.14%, 11.97%, and 11.97% for HDV, PEY, and the SPDR S&P 500 Trust ETF ( SPY ). The growth-oriented SPY was more successful, but that was primarily a function of the market environment at the time. High dividend ETFs like SPHD, HDV, and PEY closed the gap last year, all gaining while SPY fell 18%.

In other words, investors in high-dividend ETFs are unlikely to get crushed. However, there's the potential to underperform significantly, so I only advise chasing yield if you need it, not want it.

Seeking Alpha gives SPHD an "A-" Dividend Grade, likely based on its high 3.85% trailing dividend yield and 18.40% ten-year dividend growth rate. In addition, SPHD has paid a dividend for ten consecutive years. However, I don't assign any points to this metric. Since most ETFs return some distribution to shareholders, this metric is merely a function of how long the ETF has existed. In other words, it's only crucial if fund liquidation is a concern.

The 18.40% ten-year dividend growth metric is mathematically correct but misleading. SPHD's trailing twelve-month dividends are 1.7090 as of January 2023, according to SPHD's dividend history page on Seeking Alpha. The 18.40% figure is calculated by comparing it with the $0.3156 trailing dividend amount as of January 2013. However, that period only included three months' worth of dividend payments since SPHD only launched on October 18, 2012.

The correct calculation is to use the $1.0604 per share as of October 2013, when 12 payments were available. Based on the 112 months between, this works out to just 5.25%. As we move through the year, expect Seeking Alpha's Quant System to push SPHD's rating down to B+ or worse. This low growth rate was also a concern when I reviewed the ETF in November.

SPHD Reconstitution Recap

SPHD's semi-annual reconstitutions effectively add low-performing securities and delete high-performing ones. However, this straightforward "buy low, sell high" doesn't always work, as evidenced in the performance charts above. Stocks often trade at low prices because of poor fundamentals or market sentiment. According to my analysis using Seeking Alpha's EPS Revision Grades, SPHD's latest reconstitution removed 14 stocks with mostly positive Wall Street ratings. In contrast, the 14 additions were ones Wall Street has collectively downgraded. In this way, SPHD is more of a contrarian portfolio.

The Index added the following 14 securities. In most cases, it's easy to see why, as they experienced an average 18.20% loss in 2020, driving up their yields. This performance period is applicable because the reference date for the reconstitution was December 31, 2022.

These securities have an average 4.58/10 EPS Revision Score. Meanwhile, the following 14 deletions declined by 7.57% in 2022 and have an average 5.88/10 EPS Revision Score. Again, this is the Index working as designed. However, these results support my previous point about how poor-performing stocks are often that way for a reason. Wall Street may be wrong, but the risk of underperforming primarily to satisfy a high yield exists.

SPHD Analysis

Sector Exposures and Top Ten Holdings

The following table highlights sector exposure differences between SPHD, HDV, PEY, and SPY. The three high-dividend ETFs effectively target smaller-size companies, primarily in the Consumer Staples and Utilities sectors. SPHD is unique for its 20% exposure to Real Estate. PEY has 22-23% exposure to Financials and Health Care. And HDV is geared more towards large-cap stocks and has 27% exposure to Energy.

SPHD's top ten holdings include Altria Group ( MO ), AT&T ( T ), and Verizon Communications ( VZ ), with indicated dividend yields of 7.96%, 5.82%, and 6.52%, respectively. Boston Properties ( BXP ) is the top Office REIT in the portfolio, while Simon Property Group ( SPG ) is one of three Retail REITs alongside Realty Income ( O ) and Federal Realty Investment Trust ( FRT ). These ten holdings total 27% of the portfolio, while the top 25 total 58%.

Fundamentals

The following table highlights selected fundamental metrics for SPHD's top 25 companies, both post-, and pre-reconstitution. Also included are summary metrics for HDV and PEY.

A few observations:

1. SPHD's five-year beta is 0.85, marking no change from before. Constituents yield 4.56%; after fees, investors can expect to receive net distributions of around 4.26%. This estimate assumes the average price remains close to today's price and there aren't any significant increases in shares outstanding that could dilute dividend payments. SPHD's price is $44.78, and there are $88.35 million shares outstanding.

2. SPHD trades at 18.64x forward earnings compared to 18.04x pre-reconstitution. In addition, constituents have a weighted average 4.65% and 4.60% estimated revenue and EBITDA growth rate. These growth rates are near the bottom for the category, indicating dividend growth will be problematic, and investors should treat SPHD primarily as an income play.

3. The reconstitution effectively traded earnings momentum for a negligible increase in dividend yield. The portfolio has a weighted average 4.86/10 EPS Revision Score compared to 5.43/10 pre-reconstitution, offering no advantage over its peers and SPY (4.94/10). Worth noting is that HDV's 4.49/10 score is because of poor ratings among its heavily-weighted Energy holdings. Exxon Mobil ( XOM ) still looks acceptable with a "B-" EPS Revision Grade and has held strong over the last three months. However, the rest have poor grades with flat or negative returns.

4. SPHD is unique for its 20% exposure to Real Estate, where traditional growth and valuation metrics aren't applicable. However, according to estimates provided on the Hoya Capital Income Builder REIT Rankings Tracker, the average annualized FFO growth over the next two years for SPHD's nine REITs is only 4.29%. Still, some good value plays include Digital Realty Trust ( DLR ) and Healthpeak Properties ( PEAK ), priced at 14.80% and 10.60% below their category average NAVs.

Finally, Boston Properties is a bet on work-from-home policies softening this year. According to the "Back To Work Barometer" provided in this article , Office Utilization Rates improved to 60% in January, though they remain around 45% for cities with longer average commute times. Hoya Capital expects utilization rates around 60% for these regions, implying a three-day work week. That should boost the entire sector, easily the worst-performing since the pandemic.

Investment Recommendation

SPHD has a high dividend yield but poor sales, earnings, and dividend growth expectations. Constituents yield 4.56%, indicating shareholders should net approximately 4.26% after fees. However, their five-year dividend growth rate is only 5.28%, consistent with the fund's 5.25% growth rate since October 2013. Furthermore, SPHD's 18.64x forward earnings valuation is elevated compared to peers like HDV and PEY.

SPHD's last semi-annual reconstitution substituted 14 companies, resulting in no change in the portfolio's 0.85 five-year beta and only a negligible increase in dividend yield. The reconstitution also sacrificed a significant amount of earnings momentum, which was disappointing. SPHD faces an uphill battle against Wall Street analysts, and I don't recommend it other than as a pure income play.

For further details see: