Older ETF Dividend Strategies Are Fading

Allocators and investors in the smart-beta ETFs are arguably acknowledging that active and
rules-based strategies offer more dynamic solutions for the current global investment
environment.
Flows in these vehicles have increased significantly this year. When choosing a smart-beta
fund, many allocators have used similar evaluation approaches as they would in the actively
managed mutual fund space. In this world, fees and performance are key. We believe there is
a lot to be desired with this approach.
In the active investment world, allocators prefer a manager to have as long of a track record as
possible. This is true even though their investment approach likely has changed, or has at least
been tweaked, over time. Similar to their approach to selecting an active manager, investors
capital has also focused on smart-beta products with significant assets under management.
There is a lot of that makes sense with this.
Rethinking Smart-Beta Approach
With size comes scaleand typically, cost advantages in the form of cheap expense ratios and
liquidity. Despite this, we believe investors need to rethink their approach to selecting smartbeta products, and recent flows have shown that the marketplace is beginning to agree.
Ignoring potential undisclosed frictional costs associated with some of the largest smart-beta
ETFs can be costly. Unlike active managers, smart-beta ETFs do not consider overlapping
portfolio positions and rebalancing activity in other products, and their investment process
rarely develops over time.
Instead of tweaking (improving) an existing product with significant assets under management,
ETF issuers more times than not will opt to launch an entirely new product with those tweaks.
For these reasons, we believe investors need to rethink their approach to sticking by the old
guard or run the risk of missing out on some of the most innovative and creative approaches
available today.
There are approximately 850 smart-beta ETFs in the U.S., with just under $500 billion in AUM.
To put that into perspective, there are more than 1,800 ETFs, coming in at over $2 trillion in
AUM in aggregate. That makes smart-beta products almost 50% of the ETF offerings available
to U.S. investors, representing about a quarter of the overall AUM.
U.S. dividend tilts have been the most successful form of smart-beta funds by assets, coming
in at $80 billion in AUM. The four largest dividend ETFs all top $10 billion in assets, and
measure in at $57 billion in aggregate, making up over 72% of the dividend ETF assets under
management:
All four ETFs listed above were created between 2003 and 2006. Three of them rebalance just
once a year, while the fourth rebalances twice a year (SDY rebalances quarterly between
current constituents, but the index constituent list changes only once a year).

Three of the indexes behind these ETFs even rebalance on the same day, the third Friday of
March. Two of them include methodologies requiring either 10 or 20 years of continuous
dividend increases for a stock to be eligible. One only selects from stocks listed on the Nasdaq.
All other U.S. equity ETFs in the $10 billion club are linked to broad style box/sector, marketcap- weighted indexes, or indexes often covered by the media such as the PowerShares QQQ
(QQQ | A-65) and the SPDR Dow Jones Industrial Average Trust (DIA | A-85). It should be
noted that Guggenheim S&P 500 Equal Weight (RSP | A-80) is the closest nonmarket cap to
the $10 billion club outside of these four, at $9.76 billion as of Dec. 11. The hunt for yield has
been here for a long time.
How Similar Are These ETFs?
Many allocators have used these ETFs interchangeably in their strategies. The overlap chart
below shows how uniquely different these baskets are:
Overlap
VIG
DVY
SDY
VYM
VTI

VIG DVY SDY VYM VTI

6%
35% 16%
29% 26%
19% 13%

22%
16%

37%

What Are Flows Indicating?

The iShares Select Dividend (DVY) and the Vanguard Dividend Appreciation (VIG)
experienced outflows of more than $1 billion year-to-date (the Vanguard High Dividend VYM
has led all dividend ETPs in inflows, with more than $1 billion coming in this year):
5 Biggest Inflow/Outflow In US Dividend ETP Space Year-To-Date
Name
Vanguard High Dividend Yield
ProShares S&P 500 Dividend Aristocrats
WisdomTree US Quality Dividend Gr
PowerShares S&P 500 High Div Low Vol
WisdomTree MidCap Dividend

Ticker
VYM
NOBL
DGRW
SPHD
DON

Est Net Flow YTD ($)

1,048,033,586
444,788,500
321,286,325
283,747,000
215,832,983

WisdomTree LargeCap Dividend

iShares Core High Dividend
SPDR S&P Dividend
Vanguard Dividend Appreciation
iShares Select Dividend

DLN
HDV
SDY
VIG
DVY

-597,735,041
-861,785,500
-865,872,247
-1,315,241,090
-1,551,166,000

It seems allocators are starting to consider newer products. Of the five ETFs listed above with
the biggest inflows YTD, three have inceptions starting after October 2012; and of the five
ETFs with the biggest outflows YTD, four have inceptions prior to July 2006.
Some Different Approaches
There are many interesting approaches to seeking dividend beyond these four traditional
options. Here are a few different ways to approach a portfolio seeking dividends:

Maximize Dividend per unit of risk: Get as much yield as possible in as small of an
allocation as possible, in a low-volatility approach
o GlobalX Super Dividend (DIV | B-39)

Access Dividend Growers instead of focusing on maximizing current distributions

o WisdomTree US Quality Dividend Growers (DGRW | A-89)
o iShares Core Dividend Growth (DGRO | A-85)

Quality Screens
o FlexShares Quality Dividend (QDF | B-86)
o OShares FTSE US Quality Dividend (OUSA)

Dividend Growth without equity exposure

o Reality Shares (DIVY)

Discounted Closed-End-Funds
o PowerShares CEF Income Composite (PCEF)
o YieldShares High Income (YYY)

How much money could theoretically trade because of index rebalances on the third Friday of
March?
Taking a very basic approach to this question, lets look at the average expected dollars
rebalanced for each four of these funds:

Fund

#
Annual
Turnover
Ticker Rebalances
Ratio %
(constituents)

Vanguard High
VYM 2.00
Dividend Yield
SPDR
S&P
SDY 1.00
Dividend

Net Assets ($)

(Turnover / Rebal) *
Assets ($)

12.00

11,428,546,755 685,712,805.30

28.00

13,122,897,718 3,674,411,361.04

Vanguard
Dividend
VIG 1.00
Appreciation
iShares
Select
DVY 1.00
Dividend
Total

20.00

19,579,076,154 3,915,815,230.80

20.00

13,463,550,366 2,692,710,073.20
57,594,070,993

Its theoretically possible that $7.3 billion worth of dividend stocks rebalances on the third
Friday in March. This highlights one of the growing concerns in the ETF industry. Few ETFs
out there have position limits (i.e., a maximum 5% from any one company), but almost none
consider the impact they are having on the actual positions held within the fund.
Throw in the added layer of me too products attacking popular investment themes, and its
possible ETF ownership of specific securities can become extreme and potentially dangerous
when aligned with a popular investment theme.
Can This Impact Underlying Stocks?
While we are not claiming this name will have an increased or decreased weighting in future
rebalances, the performance of Mercury General Corp. could be greatly affected by these
particular ETFs.
While this is a rather small company, 9% of its market cap, and 18% of its float-adjusted market
cap, are owned by these ETFs. Whats also interesting to note is that VIG has no allocation in
any of the holdings listed above. This is because all but two trade on the NYSE instead of the
Nasdaq, which is the pool of stocks VIG will select from. Its also interesting to note that only
SDY is currently listed in its creation basket on Bloomberg.
Thoughts to Consider On Smart Beta

A long track record is not always a good thing for smart-beta ETFs. Active management
can tweak their approach over time. Indexes can, in some cases, get stale. Instead of
tweaking them, ETF issuers have often opted to create a new product instead.
Size is not always your friend. Higher turnover and size can be a hindrance to future
performance. Additionally, potentially high ownership of companies with smaller
market caps can create inefficiencies and undisclosed frictional costs for shareholders.
Overlapping holdings between smart-beta ETFs with similar mandates (in the case here,
dividends) can cause undisclosed frictional costs for shareholders.

Overlap of rebalancing between smart-beta ETFs with similar mandates can cause undisclosed
frictional costs for shareholders. Additionally, for certain approaches, you might consider an
option that can rebalance at least four times a year, especially if its a very concentrated strategy
with high active share.