The Innovative Side Of Dividend ETFs

February 13, 2017

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.

 

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