The Innovative Side Of Dividend ETFs

Reality Shares is a small ETF issuer trying to break into the competitive dividend-focused ETF landscape with some of the most innovative strategies we’ve seen recently. Eric Ervin, president and CEO of Reality Shares, tells us what sets the company’s ETFs apart, and what’s been the biggest challenge to growing assets. Reality Shares has four ETFs in the market today, with combined assets of about $55 million. They include:

• Reality Shares DIVS ETF (DIVY), $43 million in AUM
• Reality Shares DIVCON Leaders Dividend ETF (LEAD), $6.6 million AUM
• Reality Shares DIVCON Dividend Guard ETF (GARD), $2.6 million AUM
• Reality Shares DIVCON Dividend Defender ETF (DFND), $2.4 million AUM

Chart courtesy of StockCharts.com

ETF.com: DIVY is your largest fund, and it’s a complex strategy. How do you explain it in simple terms to advisors and investors?

Eric Ervin: There’s been an evolution in how we explain this strategy. I was an advisor for 20 years at Morgan Stanley, working with ultra high net worth clients. Back then, interest rates were 5-6%, so clients could get bonds paying 7-8%, which made them a great diversifier for stocks. When stocks went down, bonds went up, and in the meantime, you earned a good return.

But as interest rates came down, we had to look for alternatives. We looked at absolute-return-type strategies, and found this type of strategy [DIVY] was among them, which was so compelling, but it wasn't available to individual investors.

So, what is it? It's a marketplace that institutions have used for years, where they invest in the dividend growth rate of the market, and not in any of the stock market exposure. Imagine if you could just capture the growth rate of the S&P 500 dividend, but you didn't worry about whether stocks were going up or down; you were only concerned with whether or not dividends were rising, because that was the primary driver of all the holdings in your portfolio.

This is important, because dividends almost always go up. The average dividend growth rate is about 6.5% for the last 45 years. There've only been three years where dividends didn't rise in that period—two of those years were single-digit declines, and in 2008, they were down 18%.

ETF.com: This fund is built around the idea that there’s a consistent mispricing in the options market, correct? The portfolio is all options. How can you assume that these pricing errors are going to persist long term?

Ervin: When we originally launched the fund, we were capturing that dividend risk premium in the options market. There's another way to do it, and we've since evolved the portfolio to trade in what's called a “dividend swap.” And it's very clean. It has the same profile from a return perspective, but it's a lot easier to execute now that we're of size, because the minimum typical investment is about $30 million to $50 million in order to capture the dividend in a swap.

There's a consistent mispricing of dividends. And it's not a fluke; there's a reason for it. It's that dividends may or may not grow, so markets aren't going to perfectly price in dividend growth. There are times when dividends go down and times when dividends don't rise as much as you might’ve expected.

For that, the dividend risk premium—which would be the fancier word—is priced pretty much appropriately, so you can earn approximately whatever the risk-free rate is, plus a 3-4% return. That's why it becomes this absolute-return strategy where it doesn't matter what's going on in the world, you're probably going to earn somewhere around 3-5% over what would otherwise be T-bills or something similar.

ETF.com: So this performance is pretty consistent? Is it a smooth ride?

Ervin: Yes. If you look at the performance last year, the standard deviation on DIVY’s net asset value was around 3.5%, which is much less than stocks, and almost equal to the Barclays Agg. Yet the returns are nearly double or triple that.

Last year, we were up almost 8%, with a standard deviation of around 3. That's like a hedge fund return. Another way to look at it is if dividends generally rise 6.5% and the market knows that they're going to rise some, then the market will price in about 1-2%, and you will earn the difference. And that's how you arrive at that 3-6% return with very low volatility.

ETF.com: How do you compare DIVY’s performance to long/short equity funds in the market? Or what’s DIVY’s main competitor?

Ervin: The best one to compare it to would be the IQ Hedge Multi-Strategy Tracker ETF (QAI), which is basically designed to deliver stable returns without much volatility. A lot of long/short funds have a lot more volatility.

Look at the Sharpe ratio: Essentially, give me all of the returns, divide it by the risk, and that's my overall dream ratio that I want to be as high as possible. Based on that ratio, DIVY is the best-performing ETF of all of the alternative ETFs, because that risk-adjusted return—which is the nirvana of all ETFs—is so high; it's 2.0.

And DIVY doesn't have any correlation to bonds. It doesn't have any correlation to hedge funds. And it doesn't have any correlation to stocks. It has low risk, good returns and no correlation; it’s the perfect diversifier. But it's never going to be up 15 or 20%, ever, because it's just not designed to do that.

ETF.com: In the context of a balanced portfolio, how do you see investors using DIVY? How do you implement it?

Ervin: I’d use it as a diversifier for bonds—what you used to use bonds for, which was to reduce risk and to be a safety net.

When stocks went down, you always had money to rebalance into the stock market with your bond profile. But in this world, with bonds as low as they are, and with interest rates starting to rise, bonds have a lot more downside risk than people otherwise used to think. DIVY is a diversifier for those bond assets—a lot of institutional investors such as pensions, endowments and foundations all think of it as an alternative to their bond exposure.

ETF.com: Is the current macro environment a good time to consider an absolute-return strategy?

Ervin: Yes. This is our time to shine, because the equity market has a lot more risk in it and the bond market has a lot more risk in it. People should be allocating more to strategies like this. Many of the liquid alternatives out there are really just high-priced T-bills. And if you think the hedge fund's the traditional diversifier, remember that they've really gotten a lot more correlated to stocks, so they're hiding an awful lot of equity market risk in the average hedge fund.

The other thing you have to think about is that the primary driver of DIVY is the dividends rise. Everything is pointing towards rising dividends with the new administration, as Trump wants to cut corporate taxes, which means more cash that can be paid out to shareholders. It's a really positive thing for this kind of a portfolio.

ETF.com: To touch base on your other three ETFs—the DIVCON lineup of funds—how are investors to use these ETFs? And why are they so slow to gather traction?

Ervin: These three funds score stocks based on their ability to grow their dividends. There are seven factors that go into that score—things like free cash flow, dividend ratio, share buybacks, etc. The basic premise is that we believe companies that can grow their dividends are going to perform better than companies that can't. Companies that can grow their dividends have better earnings growth, they have better management teams that care more about the shareholders. 

But we didn’t want to just buy all of the stocks in the index, and simply own a little less of the bad ones and more of the good ones. Instead, we built three ETFs:

• LEAD owns only those leading companies that can grow their dividends. LEAD is a great alternative for anyone who has money in the S&P 500. These aren't the high-yielding stocks; these are the highest-quality stocks. So it's really like a quality screen.
• DFND takes the premise that leading companies should be outperforming the laggards, so it's long the leaders and short the laggards. DFND is a perfect alternative-type strategy. If you're not quite sure if the market's going up or down, you want to be a little bit more defensive, and so have a small short position in order to offset some of that risk. When markets go down, your high-quality companies are going to go down less, and your low-quality companies, which are the short ones, are going to go down more. It's more defensive.
• GARD is the exact same concept, but it can be dynamic. Sometimes it's long only, and then when markets are starting to show signs of weakness, it can go to a long/short position. GARD is more for the person who believes in timing. Some people are morally opposed to trying to time markets, but we tested it back 50 years in identifying high-risk markets and low-risk markets. In the last 15 years, for example, it's only indicated a bearish signal during the 2000 correction, the 2008 correction and then again at the end of last year. Nothing is perfect, but it has a lot of research to back it up. For people who don't believe in that, GARD is not going to be for them.

The reason they haven't attracted a ton of assets is primarily because people want to wait and see. That’s the biggest struggle. Coming from that world and being an advisor, and thinking that advisors are willing to adopt new and better strategies and try to save their clients money, it's been frustrating.

I’ve learned that many financial advisors will say, "This is a great solution, and I understand the research, but I'm going to wait until it gets bigger, and until other advisors are using it.” They're not willing to adopt new things, which is ironic, because that's their job, to find new and better strategies for their clients, but many of them are just sitting on the same old strategies. That’s probably the biggest challenge for us.

Contact Cinthia Murphy at [email protected]