2023-09-21 10:10:54 ET
Summary
- The iShares Select Dividend ETF has underperformed the S&P 500 due to its overweight exposure to Utilities and Financials sectors.
- Prolonged weakness in these sectors presents a buying opportunity for DVY.
- DVY offers an above-average yield of just under 4% and has shown positive dividend growth this year.
Main Thesis & Background
The purpose of this article is to evaluate the iShares Select Dividend ETF (DVY) as an investment option at its current market price. The strategy of this fund is " to track the investment results of an index composed of relatively high dividend-paying U.S. equities".
I had a neutral outlook on DVY earlier this year. I was more bullish on large-cap stocks and other growth opportunities, and I felt DVY wasn't doing itself any favors with the overweight Financials exposure. Looking back after six months, I was spot-on with this assessment. The fund has gone nowhere while the S&P 500 has marched markedly higher:
Fund Performance (Seeking Alpha)
The good news for investors now is that I believe this opens up a value opportunity. DVY is loaded with exposure to Utilities and banks, and those are plays that have under-performed YTD. While that could continue, sector investing does tend to balance out over time. When I see prolonged weakness in sectors like those, it piques my interest for a buy opportunity. Further, DVY has some other attributes that I see serving it well in the future. As a result, I am upgrading my rating to "buy" and I will explain why in detail below.
Why Under-Performing? Top Sector Holdings
To start this review off, I thought I would take some time to reflect on why DVY has not been performing very well in 2023. This is important because it will help readers gauge whether or not now is truly a good time to buy or build on existing positions. The simple fact is that DVY has roughly half its holdings tied to either the Utilities or Financials sector - an important consideration:
DVY's Sector Breakdown (iShares)
Now, I am not suggesting this is "bad" - quite the contrary. But it helps explain why DVY has fallen behind the S&P 500 in such a wide fashion. While Financials are up for the year, it is still one of the weaker-performing sectors across the market. And Utilities, unfortunately, are one of only two sectors in the red since January:
Sector Performance (Fidelity)
This should shed some light on why DVY has not managed a profit. Both of these sectors have struggled in 2023 - albeit for vastly different reasons.
Financials in particular have dealt with the fallout from bank failures such as Silicon Valley Bank, among others. DVY holds large-cap institutions, but not just the mega-banks that largely avoided this headwind. The pressure on the sector still concerns investors as the safety and soundness of smaller - especially regional banks - are called into question.
For Utilities, the story has been mostly about interest rates. As rates have gone up consistently in 2023, income-oriented investors have rotated out of the sector and into other areas (such as bonds) that are now yielding historically high levels (based on the last decade). This is not something that is set to change in the short term if today's Fed meeting is any indication.
The positive is we are probably near "peak" levels in terms of the Fed's benchmark rate. But Chairman Powell made it clear in the press conference this afternoon (9/20) that rates would be held in "restrictive" territory for a while:
Powell Quote (Federal Reserve)
The implication here is that if investors have moved out of Utilities because interest rates are high, then the current outlook may not be enough to draw them back in. In my personal opinion, I see a Fed "pause" as merit to buying Utilities. The sector is well-supported (more on that to come in this review) and I think federal dollars will continue to flow into these companies.
But the challenge is that my opinion is not what moves markets.
I Like Bonds, But I Like Equity Dividend Payers More
I will now shift to a broader, more macro-discussion on why I like dividend equity ETFs for the time being. This is generally my preferred way to play the market beyond the broad market funds that I own (think S&P 500 and NASDAQ 100 ETFs). As a "dividend seeker", it should be clear that I like income-oriented equity options - whether pure stock plays or funds.
But investors have options when it comes to income. Bonds are starting to grow in attractiveness for many as the Fed nears the end of its rate-hiking cycle. Yield are high, on average, for treasuries and even corporate and muni bonds are drawing interest as investors want to lock in income streams that may be set to decline in 2024. The simple logic is - it may not pay to wait if you are a bond investor if rates go down next year!
But the yield on the surface is not the only factor to consider. As investors in the bond market will know - the last year and a half has been anything but normal. Bonds had a rough 2022 and 2023 has only been marginally better. While yields have risen, volatility has too. This has made the journey for investors less pleasant than they may be used to.
On the bright side, volatility has come down in the bond market in the short term. But we have to acknowledge that it remains elevated over a longer time horizon, as shown below:
Move Index (a measure of bond market volatility) (Bloomberg)
What I am trying to demonstrate here is that if one is income-oriented, as I am for a good chunk of my portfolio, then perhaps dividend plays are really the superior option. In the case of DVY, it yields the same as many bond funds do, too. And bonds have seen their volatility spike in the past two years. This makes it less of an equity/portfolio hedge than they have been in the prior cycles. For this reason, I prefer adding cash to funds like DVY rather than passive bond funds by comparison in Q4.
Dividend Has Grown This Year
Expanding on the prior paragraph, the attribute to keep an eye on is the fund's dividend. Given the ETF's approach, an above-average yield with some growth is what I would expect before buying or holding this fund. Fortunately, DVY has both at current levels. The SEC yield clocks in just under 4%, which I find enticing for an equity fund:
DVY's SEC Yield (iShares)
Further, DVY has managed to squeeze out some positive dividend growth this calendar year, checking off the second expectation:
Jan - June 2022 Distributions | Jan - June 2023 Distributions | YOY Growth |
$1.75/share | $1.81/share | 3.4% |
Source: iShares
The conclusion for me is DVY is meeting its objective. The yield is above-average and growing. While this alone is not enough to buy it, it is a definitive supporting factor.
Demand For Utility Services Remains High
As I mentioned above, the dividend is not the sole reason for buying (or not buying) DVY. So what are some of the other reasons?
The first one would be one's outlook for the Utilities sector. At over 27% of total fund assets, clearly one would want to be bullish on this area before buying it. If Utilities perform poorly, DVY is going to be hard-pressed to generate much of a return. We don't have to look further back than 2023 to recognize this reality.
But I am a long-term bull on this sector for a variety of reasons. For one, it is under-represented in the S&P 500, so it serves as a great portfolio diversifier. Two, as mentioned already, the yield on the sector tends to be attractive. A third reason is that the services the sector delivers to Americans remain as in-demand and relevant as ever. This is due to a shift to more electrification, a growing population, and more single-family homes being built. Net result: a much higher demand for electricity over the past two decades:
Retail Electricity Use (Retail (US)) (Energy Information Administration)
The trend is your friend here - and this trend is not going anywhere. This convinces me that Utilities are a spot to be now and in the future.
Beyond just demand for the services, the sector is undervalued compared to the broader market. This is a direct result of the performance mismatch we have seen this year. As the S&P 500 has risen and Utilities have fallen, what has resulted is a very interesting entry point for the sector by comparison:
Whenever I see glaring signals like this, initiating or adding to an existing position is really the only move I make. Today is no exception.
The final point I will mention is that a host of utility funds (some of which are in DVY's portfolio) have cases pending before their regulatory boards to raise prices on end consumers. These are by no means guaranteed - and many requests often get watered down before they are improved. But even still, if just a portion of these requests are honored/accepted, then the sector is poised to grow revenue due to rate increases in 2024:
Obviously, DVY is not solely a "Utilities" fund, but it does hold a significant portion of its assets there. So this discussion is valid for it, but also for any number of ETFs that are either sector-specific or, like DVY, hold a large allocation to the sector. Given this positive backdrop for Utilities, it should not be a surprise I am upgrading my rating on DVY here.
Bottom Line
When looking for investment opportunities, under-performers aren't always the best place to start. That may make my upgrade here curious to my followers. But I see merit to it in this case. DVY has seen its yield grow in 2023, the underlying sectors (especially Utilities) look ripe for a rebound, and equity dividend ETFs should probably edge out bond options going forward on a risk-adjusted basis. Therefore, I feel comfortable shifting to a "buy" rating here, and I suggest readers give this idea some consideration at this time.
For further details see:
DVY: Poised To Move Higher Going Forward (Rating Upgrade)