Under the Hood: A Deeper Dive into Dividend ETFs (Archand)

by Noel Archand, iShares

In a recent post I wrote about ETFs and their names. I explained that while a name can give investors an initial hint as to what type of exposure an ETF offers, it’s worth “looking under the hood” to see what a fund holds before deciding to add it to your portfolio.

This post is the first in our new “Under the Hood” series, which is intended to explain similarities and differences among the ETFs that we offer and help you make more informed investment decisions.

Today, I’ll concentrate on two of our dividend funds – the iShares High Dividend Equity Fund (HDV) and the iShares Dow Jones Select Dividend Index Fund (DVY).

Dividend investing has played a significant role in portfolio construction for decades, with dividend yielding stocks providing investors the opportunity to profit from price appreciation and dividend income. But with government bond yields at historic lows and interest rates expected to stay low for quite some time, dividend ETFs are garnering a fresh look from investors.

Dividend ETFs offer investors efficient, diversified exposure to dividend stocks, which can be difficult and time-consuming to pick individually.

HDV and DVY both offer investors exposure to dividend investing. But HDV’s top five holdings as of November 2 were AT&T, Pfizer, Johnson & Johnson, Procter & Gamble, and Verizon, while DVY’s top five holdings as of that date were Lorillard, VF Corp, Chevron, Entergy and Kimberly-Clark.

Why do their holdings vary so greatly? To begin with, the funds track different indices that use different screening processes.

HDV, which launched in March of this year, tracks the Morningstar Dividend Yield Index. It’s concentrated in mega- and large-cap companies that have been screened using both Morningstar’s Economic Moat and Distance to Default measures.

Economic moat, a phrase coined by the Oracle of Omaha — Warren Buffett – refers to a company’s ability to maintain its competitive advantage versus its peers and rivals. Morningstar uses it to measures the sustainability of a company’s future profits, while it uses distance to default to measures a company’s probability of default.

DVY, which was launched in 2003, tracks the Dow Jones US Select Dividend Index. It includes stocks of varying market caps, but stocks must have 5 years of non-negative dividend growth in order to be included.

HDV can be thought of as offering a forward looking methodology, while DVY offers more of a backward looking methodology (remember that 5-year historical hurdle companies must overcome). So HDV can hold a company like Philip Morris, which was spun off from Altria in 2008, while DVY cannot.

Also, DVY does not limit the sector weights of its holdings. So as of November 2, utilities accounted for 35.17% of its holdings, while consumer goods accounted for 21.11% and industrials accounted for 12.96%.

But sectors weights are limited in HDV because the distance-to-default screen excludes companies in the bottom 50% of their sectors. As of November 2, health care accounted for 26.72% of the fund, while consumer goods accounted for 22.3% and utilities accounted for 17.72%.

If you are following Russ’ market commentary and want exposure to the energy sector through utilities, DVY could be a possible addition to your portfolio. If you prefer defensive equity exposure through health care in these uncertain times, HDV could be a more appropriate investment.

Both ETFs offer exposure to the consumer sector. If you believe consumers will continue to spend on tobacco (think Lorillard ), clothes (think VF Corp’s Wrangler jeans and Timberland boots), Kleenex (think Kimberly-Clark) and fast food (think McDonald’s), then DVY offers exposure to that type of consumer spending.

HDV’s consumer goods slant is slightly different, offering exposure to that sector through cell phones (AT&T and Verizon), Crest toothpaste and Tide detergent (Procter & Gamble) and tobacco (Philip Morris).

As I mentioned in my earlier post, a name may be an initial hint as to what type of exposure an ETF offers, but there’s always more to the story. HDV and DVY both offer dividend exposure but provide it in different ways.  It’s worth taking the time to look under the hood to determine which fund best suits your dividend needs.

Diversification may not protect against market risk. Narrowly focused investments typically exhibit higher volatility. There is no guarantee that dividends will be paid.

Holdings are subject to change. There is no guarantee or implication that any specific companies will remain in any fund.

Copyright © iShares