Hidden Gem ETFs

December 01, 2017

Fidelity Dividend ETF for Rising Rates

What do you do about the threat of rising rates? It’s a question investors are asking themselves over and over right now. Unfortunately, the answer isn’t always apparent. Rotating into lower-duration fixed-income securities helps on the bond side, but what do you do on stocks?

Enter FDRR. If there’s one thing we love about this ETF, it’s that it puts the actual problem it’s trying to solve right there in the name. It’s a dividend ETF for rising rates.

But it’s more than that. With its careful constraints, FDRR works as a new core holding for investors. And with a clever design, it’s definitely a hidden gem.

Matt Hougan, CEO, Inside ETFs: What drove you to develop FDRR?
Matt Goulet, ETF Investment Strategy, Fidelity Investments: FDRR really came from our customers. We constantly heard from investors and advisors that they were searching for income but were concerned about the risks that came with other dividend strategies, particularly the impact of rising interest rates.

Dividend ETFs have been on the market for almost 15 years. At the time they launched, the 10-year Treasury was yielding somewhere between 3.5-5%. Many of the early ETFs had methodologies that relied heavily on the history of the underlying stocks, and specifically looked for stocks that had increased their dividend for many consecutive years—5, 10, 20, etc. They also had different weighting schemes.

What’s wrong with that?
Well, the question is, what’s changed? And the answer is, bank stocks that had long histories of paying dividends didn’t hold up so well in 2007 and 2008, and on top of that, technology companies started to pay dividends in recent years.

Some of the more mature tech names like Cisco yielded less than 1% five years ago; today, Cisco is yielding north of 3%. We are in a different dividend environment. When our product group got together with our Equity & High Income Quantitative Research team, we thought we could develop something better. So, when we were designing FDRR, we started by capturing that new dividend reality, and then incorporated the risk we kept hearing about: rising rates.

Is there something about dividend ETFs that makes them uniquely exposed to rising rates?
Many dividend ETFs are exposed to rising rates because of their significant tilts toward sectors and industries that are very interest rate sensitive—such as utilities or REITs. There is a big dispersion between competing dividend ETFs, because most of them are unconstrained. There is nothing to govern sector and industry overweights.

With FDRR, we make sure it’s sector- neutral versus a market benchmark; it’s size neutral versus a market benchmark; and all the individual securities bets are constrained. You don’t see FDRR making massive sector, size or individual company bets versus the market.

How does it fit in an investor’s portfolio?
We feel it can be a core holding for income-oriented portfolios. If you look at the tracking error versus the Russell 1000 for FDRR, it’s low. Other dividend ETFs will exhibit tracking error of 5-10% per year versus the Russell 1000; FDRR will likely be much tighter than that based on our constraints. FDRR works for investors searching for yield, and can play a core role in such an investor’s equity allocation.

What does it typically replace in investor portfolios?
Many think of ETFs as taking assets away from traditional active funds, but we see a lot of money coming from both dividend ETFs launched in the early 2000s and also individual blue chip stocks. It’s not just people selling mutual funds and buying ETFs; it’s people ditching individual stocks and buying dividend ETFs instead.

What does it yield today versus the S&P 500?
FDRR has a yield of 3%, and the weighted yield of the underlying companies is 3.6%; the market overall is about 2%.

When does the fund perform well versus the market as a whole, and when does it perform poorly?
Broadly speaking, FDRR will do well against the market as a whole when dividend stocks are outperforming the market or when cheap stocks are outperforming the market, because value and dividends are closely related.

Another way to address this question is, how will it work versus dividend ETF peers? Compared to peers, FDRR will likely outperform other dividend ETFs in a rising rate environment.

It will underperform other dividend ETFs when rate-sensitive sectors like utilities and telecom are performing well. We only have a 3% weight to utilities and a 2% weight to telecom. Meanwhile, some of our competitors are 30-40% utilities and 10-20% telecom. It’s a sizable difference.

What drives that difference?
We’re not underweight utilities versus the market; we’re sector neutral. The overall market is only 3% utilities and 2% telecom. We pick names within a sector for yield, but the weight of the overall sector is matched to the weight of that sector in the overall market at the annual rebalance.

What’s the expense ratio, and how did you set that?
The expense ratio is 0.29%. If you look across the smart-beta and factor space today, we priced it below where most funds are priced. Given that it incorporates a lot of insights from our investment team and is priced below many peers, we think it’s a strong value.

If you had to sum up FDRR in one paragraph, what would you say?
FDRR is the second era of dividend ETFs. Just when you think ETFs have reached their peak and there is no more room for innovation, we see firms like Fidelity and our competitors coming up with new ideas.

You hear the term “solutions” thrown around our industry a lot, but with FDRR, we’re actually providing a real solution. We identified a need, thoughtfully designed the product, and then we were explicit about what it does. We put the term “for rising rates” in the name. People often ask what ETFs do; we tried to make that clear. It’s a true solution for an advisor or an investor.

Find your next ETF

Reset All