Choosing Dividend ETFs Should Interest Rates Fall

Investors looking to move cash out of money-market accounts ahead of any potential Federal Reserve interest rate cuts may seek dividend-paying exchange traded funds. 

During the Fed’s rate tightening cycle, investors moved trillions into cash accounts and safe T-bill ETFs that paid 5%. If rates fall, that money seek out at a different home. While the market currently has almost no expectation of a rate cut at the next meeting of the Federal Open Market Committee on March 20, those odds soar to 60% for a cut at the June meeting, according to the CME Fedwatch tool.

“Should short-term rates fall considerably in 2024, many of the same investors who gladly bought money market at 5% will have to consider how much yield they are willing to sacrifice in exchange for price stability,” says Curtis Congdon, president, XML Financial Group in Bethesda, Maryland.

If money-market account yields start to dip under 4%, Congdon says those investors may start looking elsewhere for relatively safe income. That could make dividend-paying ETFs attractive for investors who are willing to venture back into equities. Choosing which dividend ETF to buy in a declining interest rate depends on an investor’s goal: yield or stability.

CFRA Research classifies and analyzes the 191 dividend ETFs in their database into two categories: regular dividend payers and high-yield dividend products, says Las Vegas-based Aniket Ullal, head of CFRA’s ETF data and analytics. 

Dividend Aristocrats as Rates Fall

Regular dividend payers have paid distributions over many consecutive years and may gradually increase those payments; sometimes they’re called “dividend aristocrats,” he says. High-dividend payers are those that offer a rich yield to entice investors. They’re often more concentrated in certain sectors like REITs, he says. 

“The high-yield dividend stocks are also at risk of dividends being cut if the macro environment changes, whereas, the dividend payers tend to be a slightly safer bet,” he says. 

Knowing the difference between the two types takes reading the methodology in the ETF’s prospectus and the description of underlying index. “It’s actually not that easy” to tell from just the name, he says. 

There’s little independent research about how dividend ETFs specifically perform in a falling rate environment because it’s been nearly two decades since rates have been this high, and ETFs only gained solid traction as an investment vehicle after the global financial crisis in 2008.

Research into Dividend Strategies

Research from S&P Global looking at dividend strategies for individual stocks suggest that in an uncertain economic environment, stocks with a history of dividend growth may provide exposure to higher-quality names and greater income over time. This is the case for stocks of any market-cap. 

Congdon says in a soft-landing scenario dividend appreciation funds such as the $9 billion First Trust Rising Dividend Achievers ETF (RDVY) might do well. A firmer economy benefits companies who are focused not just on distributing cash flow but growing revenue. 

Investors seeking income in a hard landing or if the Fed aggressively cuts rates may turn to higher-yielding funds, such as the $857.2 million Franklin U.S. Low Volatility High Dividend Index ETF (LVHD), he adds.

While that fund has high dividend in its name, by adding the low-volatility factor to the selection methodology, the fund aims for a stable yield, setting it apart from simple high-yield seeking dividend ETFs. 

“Should we break the five-year trend of double-digit calendar gains or losses and have a more muted gain or loss then strong dividend yield would greatly improve total return and favor high-yield ETFs,” he says. 

Ullal says CFRA has a five-star rating on the $73.1 billion Vanguard Dividend Appreciation ETF (VIG), and four stars on the $11.5 billion WisdomTree U.S. Quality Dividend Growth (DGRW).

Ullal notes recent dividend ETF launches have tried to add nuance to their strategies, such as including more factors, like quality or low volatility, as seen in the First Trust, Franklin and WisdomTree ETFs. Another recent example is the $5.6 billion Capital Group Dividend Value ETF (CGDV). 

“It’s a category we’ve seen growth, this multi-factor approach,” he says.