Interest rates are hovering just above zero percent. The yield curve is very flat, and the Federal Reserve remains resistant to taking rates on the short end of the curve below zero. At the same time, the economy is so heavily burdened with debt, it would be highly detrimental to economic growth to allow rates on the long end of the curve to rise meaningfully.
Interest rates appear to be stuck at an ultra-low level as far as the eye can see. But banks, insurance companies, and other industries in the financial sector of the economy base their business models in no small part on safe-yielding assets like bonds and loans. In other words, the United States is now in more or less the same interest rate environment that Europe was in a decade ago, and we can see how well that turned out for the European financials sector (purple line):
Though longer duration rates have been falling in the US over the last ten years, they have not been so close to zero as rates have been in Europe. But now they are, and it seems probable that the US financials sector will face just as many challenges and headwinds for the foreseeable future as the European financials sector has in the last decade.
That makes US financials stocks — in general (there may be individual exceptions) — unattractive as long-term investments.
This is the same basic case I made in my June article on the WisdomTree U.S. Dividend ex-Financials ETF (DTN). The ETF is probably the single passive-index fund that comes closest to replicating my own stock-picking methodology. Though I am a long-term dividend growth investor, I generally find it difficult to get excited about stocks yielding less than 3%. Thus, DTN’s tilt toward relatively high yield and avoidance of financials is a perfect fit for my investing goals and philosophy.
With a moderate expense ratio of 0.38% and a 3.0% dividend yield based on the previous twelve months of dividends, DTN is an attractive way to gain exposure to moderately high dividend stocks in a zero interest rate world.
First off, it should be noted that DTN has meaningfully underperformed its broader dividend ETF peers over the last ten years, and especially the last five.
I believe that pertains to the way in which DTN continually veers toward value stocks by design.
To recap the previous article, DTN’s stock-picking methodology begins with narrowing down the universe of dividend-paying stocks to large-cap companies with highly liquid shares. But once past the large-cap filter, the ETF does not weight stocks by market capitalization. Instead, the weighting is by dividend yield.
This accomplishes two things. First, it diversifies the sectoral weightings of the fund so as to prevent a few mega-cap companies in technology or consumer discretionary from dominating. In fact, besides the obvious omission of financials, DTN is one of the most diversified dividend ETFs out there, with no sector making up more than 12.5% of the portfolio.
Source: WisdomTree DTN Webpage
Notice the highly defensive tilt of the sector allocation, with consumer staples making up the top spot.
The second thing that a yield-weighting does is give the ETF a value tilt. Obviously, when stocks have sold off or underperformed, their valuations get cheaper. Of course, cheapness does not necessarily mean “good value,” but those that maintain their dividends and pass DTN’s other screens are more likely to be a good value than those that don’t.
Weighting by dividend yield doesn’t make DTN a “high yield” or “high dividend” ETF, though, because it does not filter out low-yielding stocks. It just gives them a lower weighting at each rebalancing. In contrast, stocks that have seen their yields rise since the last rebalancing will receive a larger weighting at the next rebalancing.
Assuming the stocks that pass DTN’s other filters are solid companies, this regular rebalancing toward higher yielding stocks is effectively a value tilt. It rebalances from lower yielding and presumably higher valued stocks to higher yielding and presumably lower valued stocks.
For some investors, a value tilt will be an attractive quality. For others, it may be a deterrent. After all, growth stocks have massively outperformed value stocks over the last ten years and especially the last five years.
To return to the first chart shown in this section above, this value orientation is probably a big reason why DTN has underperformed most of its dividend ETF peers in the last ten years. By regularly rebalancing toward higher yield, the ETF doesn’t allow its winners to run very long before being cut down to size.
With 89 total holdings, the average weighting is 1.12%. There are 39 holdings with that weighting or higher, while the remaining 50 holdings have smaller than average weightings.
Source: WisdomTree DTN Webpage
Compared to the last time I analyzed DTN on June 19th, there are only two changes to the top ten holdings. Dow Inc. (DOW) and WestRock (WRK) came in, while Dominion Resources (D) and W.P. Carey (WPC) slipped out. Both of the latter two stocks are still in the portfolio, just not the top ten.
The bottom four holdings in the portfolio are Sirius XM (SIRI), Activision Blizzard (ATVI), Viacom CBS (VIAC), and International Flavors & Fragrances (IFF), which gives you an idea of how low the dividend yields can go.
Though the top ten stocks give the impression that DTN is a high yield stock ETF, they are merely a reflection of the ETF’s yield-weighting and value tilt.
As I discussed in my previous article on DTN, the ETF’s annual dividend growth from 2009 to 2019 was around 8%. If that same dividend growth rate persisted for another ten years, buying in at the current 3% dividend yield would render a yield-on-cost of 6.5% in ten years.
While by no means exciting, that YoC is decent and dependable. I believe that to be the case because many of the portfolio’s holdings are stocks that I own individually. They are companies that I have researched and believe in. While they are not all names I would include if I were to reconstruct a similar fund from scratch, they are well-chosen and weighted in a way I like.
Since my own portfolio of individual stocks is mostly concentrated in REITs (real estate investment trusts), I find DTN a smart way to increase my allocation to non-real estate stocks while maintaining the same core investment philosophy and methodology.
DTN is now the largest ETF in my Roth IRA, and in that retirement account I only invest in ETFs and mutual funds. It is the kind of ETF that I will probably add to on any meaningful pullback, but the current price does not strike me as a steal right now.