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Shopping For High Dividend ETFs? Beware Volatility

This article originally appeared in the October issue of REP. Magazine and online at Wealthmanagement.com Yield-starved investors turn to high-dividend payers to squeeze out some cash flow, but how do you squeeze extra yield out of the market without blowing your risk budget? In today’s low-yield bond market, it’s no wonder income-oriented investors have looked to dividends for supplemental cash flows. In February 2011, ten-year Treasury notes were paying nearly two percentage points more than the S&P 500 dividend yield (see Chart 1). The yield premium has since plummeted and, at times, actually turned into a discount. Blue Chips Stalled The ten-year and blue-chip benchmarks are now pretty much stalled at a two percent yield, forcing many investors to cast about for better-paying opportunities. Especially enticing are high-dividend exchange-traded funds (“ETFs”), which offer cash flows nominally devoid of duration and interest rate risk. Seven have track records stretching back more than five years: The 100 stocks making up the iShares Select Dividend ETF (NYSEARCA: DVY ) are screened on the basis of dividend growth and sustainability. Utilities account for more than a third of the portfolio’s capitalization. Financials, mostly REITs, come in second. The 50-stock SPDR Dividend ETF (NYSEARCA: SDY ), which screens the S&P 1500 Composite Index for stocks with 20 years or more of consecutive dividend increases, maintains a narrower portfolio. Consequently, SDY skews heavily toward REITs. Vanguard avoids REITs entirely in its high-dividend product. The 400+ stocks populating the Vanguard High Dividend Yield ETF (NYSEARCA: VYM ) are more or less evenly weighted by sectors and tilt toward large caps. First Trust sponsors two veteran high-dividend ETFs. The larger, First Trust Value Line Dividend ETF (NYSEARCA: FVD ), is built with low-beta issues found with Value Line’s proprietary “safety rating” methodology. Not surprisingly, FVD gives over nearly a quarter of its real estate to utilities. The loose inclusion criteria of the WisdomTree High Dividend ETF (NYSEARCA: DHS ) accounts for its 900+ stock portfolio and its relatively modest sector bets. Still, financials are weighted more heavily than utilities. FVD’s stablemate, the First Trust Morningstar Dividend Leaders Index ETF (NYSEARCA: FDL ), is a 100-stock portfolio comprised of companies that have boosted their dividends over the past five years. REITs are specifically excluded. Accordingly, FDL tilts toward utilities. Rounding out the set is the PowerShares High Yield Equity Dividend Achievers Portfolio ETF (NYSEARCA: PEY ), a 50-stock portfolio of large caps selected on the basis of their ten-year dividend growth histories. Utilities figure heavily in the mix-more so, in fact, than in the other veteran funds. When interest rates sag, income-hungry investors may be tempted to chuck fixed-income exposure in favor of high-dividend funds. That’s a very risky move, however. Remember: These funds are equity products. Replacing all or part of a portfolio’s fixed-income allocation increases exposure to stock market volatility and can further concentrate risk in certain industry sectors. Choices, choices So how do you squeeze some extra yield out of the market without blowing your risk budget? The first step ought to be identifying the high-dividend funds that provide the greatest diversification. There’s a couple of ways to look at this problem. From Table 1, you can see that the First Trust FDL portfolio, in addition to offering the highest dividend yield, has the lowest r-squared and beta correlations versus the S&P 500. That makes FDL pretty different and pretty attractive. FDL, however, posts the worst Sharpe and Sortino ratios of the lot. Not a good thing. The Sharpe metric, remember, rates a fund’s risk-adjusted returns using total volatility. The Sortino ratio does the same thing but only uses downside deviation as the representation of risk. If preservation of capital is paramount, a high-dividend fund sporting the best Sharpe and Sortino ratios ought to be a top pick. That makes the PowerShares PEY fund a standout. The next problem is the allocation issue. Just how much of the high-dividend fund do you add to your portfolio? And, where do you carve out room for it? Here, a little backtesting offers clues. Suppose you’re keen on dampening risk as much as possible while keeping your commitment to a high-dividend product at 20 percent of your capital. Let’s look back at the last five years to see how PEY might have performed. Classic 60/40 Portfolio Our benchmark will be a classic “60/40” portfolio: 60 percent stocks, represented by the SPDR S&P 500 ETF (NYSEARCA: SPY ), and 40 percent bonds, proxied by the iShares Core Aggregate Bond ETF (NYSEARCA: AGG ). Taking a 20 percent PEY carve-out from the bond side (a “60/20/20” allocation) produces a significantly higher average annual return than the benchmark but yields an inferior Sortino ratio. Splitting the PEY carve-out equally from the equity and bond sides (a “48/32/20” mix) improves both nominal and risk-adjusted returns but ticks up volatility. The sweet spot’s found by carving out a PEY allocation from the classic portfolio’s equity side (a “40/40/20” exposure). There’s a minimal impact on the portfolio’s average annual return but a significant reduction in volatility and, therefore, realized risk. Both risk ratios, especially the Sortino metric, are dramatically improved at the cost of just 10 basis points in annualized returns. High div/low vol packages Some newer high-dividend ETFs attempt to entice risk-averse investors by branding themselves as “low-volatility” portfolios. The oldest of these, launched in 2012, is the PowerShares S&P 500 High Dividend Portfolio ETF (NYSEARCA: SPHD ). SPHD’s index methodology screens the S&P 500 for 50 of the blue-chip benchmark’s highest-paying and least-volatile components, tilting the portfolio heavily toward utilities, consumer staples and financials. At last look, SPHD paid out a 3.5 percent dividend. It’s no surprise that SPHD is highly correlated to its parent index. Movements in the S&P 500 explain 77 percent of SPHD’s variance. SPHD’s beta, at .76, makes the fund a middling competitor to the veteran high-dividend products. Using SPHD in a “40/40/20” portfolio pares 50 basis points off the return earned by a classic “60/40” portfolio and an equal amount from the portfolio’s volatility. The significant improvement in the portfolio’s Sortino ratio bespeaks SPHD’s defensive sector concentration. SPHD isn’t the only ETF claiming low-vol street cred. The Global X SuperDividend US ETF (NYSEARCA: DIV ) is another 50-stock portfolio that screens stocks for low volatility, but its universe includes MLPs and REITs. Thus, the fund’s high-dividend yield is north of seven percent. The fund’s equal-weighting scheme magnifies the energy and financial sectors’ influence, which perhaps explains why a portfolio including DIV has Sharpe and Sortino ratios worse than a classic “60/40” mix. As with anything, it pays to look beyond the advertising for real evidence. Volatility is relative. Investors will soon have another exchange-traded high-div/low-vol option. Legg Mason recently filed a registration statement for an ETF based on the QS Low Volatility High Dividend Index, a proprietary benchmark that culls 3,000 domestic stocks for sustainable dividends as well as low earnings and price volatility. The Legg Mason Low Volatility High Dividend ETF is expected to be listed on Nasdaq, but no ticker symbol has yet been assigned. What’s clear from this exercise is that dividends come at a cost. Each high-dividend fund is constructed differently, and each presents a unique combination of risks and rewards. The highest-yielding product may not be the best addition to your portfolio. It’s often better to accept a more modest cash flow than risk hard-earned capital.

GLD: The Hurdles Still Remain

Summary We continue to have several things working against the gold sector at the moment. I have been selling more over the last week as this rally looked to be petering out somewhat, but I still have positions established in several gold and silver companies. If gold goes under $1,000 per ounce, then it will probably be the last time you will be able to buy it at that price ever again. The bearish hurdles that I talked about a few weeks ago in my last article on the SPDR Gold Trust ETF (NYSEARCA: GLD ) are still in place. In fact, they have become even larger since that time. We continue to have several things working against the sector at the moment. Those include the divergence between GLD and the gold stocks (HUI and XAU), the long-term downtrend that is still in place, tax loss selling into the year-end, and possible interest rate hikes at the December Fed meeting. The gold sector needs to overcome these before you can even start to talk about a new bull market. The latest sell-off in the precious metal sector began in early June, and since that time GLD has almost gotten back to even while the HUI is still showing a sizable loss. There have been many instances in the past when you suddenly get big divergences that occur in terms of where GLD/gold is priced at in relation to where the gold stocks are trading, and they usually don’t last long. At one point this month, the HUI was down about 35% while GLD was only down about 2.5%. That performance gap was extreme and it simply wasn’t going to be able to continue. Since that time, the HUI has outperformed, but it’s still lagging the price of gold by a fairly large margin. One of them is right though, and one of them is wrong. Either GLD reverses hard over the short-term, or the HUI makes some substantial gains during that time. ^HUI data by YCharts Given the price action in the HUI since the Fed meeting, one could argue that it’s the gold stocks that are correct. But it’s too soon to determine if this rally since the August lows is just a bear market bounce. Technically, the gold stocks appear to be breaking down, but I don’t like to rely on events that happen immediately after a Fed meeting, as the initial move isn’t always the correct one. Without question though, the long-term trend is still down. If the HUI can’t make a charge higher over the next several weeks, then investors will most likely start taking some tax losses in these gold stocks (if they haven’t already), as many have dropped substantially since the beginning of 2015. This will further fan the flames and we could get some major declines into the end of the year. I showed the YTD percentage loss for the following stocks in my previous article. Over the last few weeks, they have decreased even more, and the chart below reflects their current losses year to date. GG data by YCharts We also have the Fed and interest rates weighing on the gold market. Last time, I talked about how the Fed has been consistent with its message since 2012, in that the majority of members have been signaling for the last three years that they believe 2015 is when the first rate hike will occur. My argument remains that the Fed is going to lose credibility if it doesn’t raise rates this year. The weak jobs data in September had everybody believing that the Fed was on hold for the rest of 2015 and maybe well into 2016. As I said in my last update: I believe that rate hikes are still on the table, and this should be clear at the conclusion of the next Fed meeting in a few weeks. If this occurs, then gold could come under pressure again. Given the following statement out of the Federal Reserve, a 25 basis point increase at the December meeting is still a high probability event: In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. Translation: baring a major decline in the U.S. and global stock markets between now and the end of the year, and assuming economic data doesn’t collapse, the Fed is most likely going to raise rates at the December meeting. GLD and the HUI could remain under pressure over the remainder of 2015, but I continue to believe this will be a “sell the rumor, buy the news” event, and gold will finally bottom soon after the first rate hike. It might not happen right away though, as there could be a slight lag. Contrary to popular belief, gold doesn’t perform poorly when rates increase. The last time the Fed embarked on a rate hike program was in 2004-2006, as the Fed Funds rate went from 1.00% to 5.25%. Gold went from just under $400 to… well, take your pick on which date and price you want to use. Clearly there was a huge bull market in gold occurring at the time. (SOURCE: FRED ) If you go back the the 1970’s, it was the same situation. And notice in both charts how gold increases immediately (or almost immediately) with the Fed Funds rate. In the chart above, gold was up about 20% in the 4-6 months that followed the first rate increase. (SOURCE: FRED ) There is one additional hurdle that the gold sector is facing at the moment, and that is the recent strength in the U.S. stock market. Anybody that has read my previous articles on GLD knows that I’m bearish on the U.S. indices. While I don’t expect a major collapse to occur, I do believe we could see a multi-year bear market with a 25-35% decline, or at best a sideways trading pattern. Stocks need to digest the massive gains that have been racked up since 2011. In other words, it’s time for a breather. But November and December are always strong months for stocks, and it seems like they are trying to have one last hurrah before finally giving way. You can see how GLD and the S&P have been trading inverse to one another over the last few weeks. Should the stock market continue to hold up, then gold wouldn’t have that firm bid underneath it as money would still be chasing these highflyers. Only when we see the S&P roll over we will see gold start to take flight. ^SPX data by YCharts My Updated Plan Of Action On October 16, in the comments section in my previous article on GLD, I told readers that I had started booking some profits in a few precious metal stocks. The reasoning was many of these were hitting their 200 day moving averages, so I thought it might be prudent to lighten up a bit. I have been holding many of these stocks since the August lows, as that is when I jumped back in. Some positions were established on the morning of October 2, as GLD had a huge move to the upside. I thought it might be wise to take some gains and see what happened over the next few weeks. My plan was to buy these positions back only if a breakout was confirmed. (Source: StockCharts.com) I have been selling more over the last week as this rally looked to be petering out somewhat, but I still have positions established in several gold and silver companies. I’m just going to hold these and see what develops. I have no desire to buy anything at the moment given the recent weakness, I would need to see some positive price action in the HUI first. Right now 104 and 130 are the two levels I’m paying attention to. Below 104 and it’s time to get very bearish, above 130 and the rally could go further and possibly develop into a bull market. As long as the HUI remains in the middle of those, then I’m just going take a wait and see approach. My Strategy With Timing This Gold Bottom I want to talk a little more about my strategy when it comes to the gold market and why I was buying in early August, even though I still believed there was more downside over the next several months. To me, this all comes down to the math and probabilities, and buying at that time was a win-win scenario. I had two options: wait for a final capitulation and preserve 100% of my capital, or start to buy in and run the risk of losing some money. This is not about the amount invested, it’s about the percentages invested. The HUI peaked at 630 in 2011, in early August it was just above 100, or an 84% decline from peak to then-current trough. I know that the HUI isn’t going to zero, as no index has ever been wiped out completely. So the question is what could be left on the downside from the roughly 100 level. The Dow declined 90% during the Great Depression, a similar decrease in the HUI would take it to 63. That price target seemed to be a very real possibility. That would most likely result in a 50% haircut in the major gold stocks that make up the index. My thought process was to buy in 20% at the August lows, and see what transpired from that point. If I lost 50% on that capital invested as the HUI went to 63, but still had 80% cash on the sidelines, then I would gladly take that. For two reasons. One, being able to buy 80% in at 63 would be an incredible opportunity for some serious long-term gains. But even if the index declined further after I bought – to say 40 to 50 – didn’t matter so much. I know that the absolute lows during capitulation events don’t hold for long, and those losses that occur at the tail end are made up in just a matter of months. It only took a few months for the Dow to double off of the bottom, and a year later it had tripled from the lows. So if the HUI plummeted to 63 or lower, it would increase back to 100 in short order. I would also quickly gain back that money lost on the initial capital outlay in that scenario. Conversely, using 20% of my allotted capital to purchase gold and silver stocks at the August lows protected me from getting behind the eight-ball, if that turned out to be the absolute bottom. I’m always trying to stay ahead of the curve. And when I get ahead I want to keep pushing that envelope and increase my distance even further. Not taking advantage of this opportunity given would have been risking losing that positioning. Plus, if the bottom was established at that point, it would have meant I would have started to buy at the absolute lows. Worse case it would be a good trade as it was clear that these stocks were turning up in the short-term. So either scenario had a very positive outcome, which is why it was a win-win type of event. Let me be clear, this is only applicable to the current price environment of the gold stock sector or when trying to time the bottom of a sector that has already experienced a massive decline. The Last Time Gold Will Trade Under $1,000? Nothing really bullish has occurred yet in the gold sector. And with all of these hurdles that it faces between now and the end of the year, it opens the door for further downside. My ultimate target since the Fall of 2014 has been 90-100 in GLD, or roughly $950-$1,000 in gold. I still believe that if there is one more decline, that it’s most likely going closer to the 90/$950 target. If that occurs, then it will probably be the last time you will be able to buy gold under $1,000 per ounce ever again. Prices of all assets continually rise over time as the money supply increases. The fair value of gold is around $1,400 an ounce (my estimate given the growth in the money supply and just looking at the current cash cost environment). That’s not going to decrease as time progresses, it’s only going to increase as the consistent trajectory of M2 is higher, not lower. Gold is no different from other goods that are produced. It costs money to extract gold from the ground, and as the money supply increases, then so do those costs. Where those costs are at gives us a good idea of where gold should be trading. But all assets can trade well above or below fair value for a given period of time. Eventually though, the rubber band gets stretched too much (in either direction) and you get a reversion to the mean or an overshoot. Gold below $1,000 would be a stretch already at current money supply levels and growth rates. In 10-20 years, it would be impossible to have gold under $1,000, given the amount of inflation that would be introduced to the system during that time. Just like today it would be impossible to have gold under $300, which is where it was at 15 years ago. So if the price does get to under $1,000, enjoy it will it last, because it will most likely be the final time gold ever trades in the three digits. That just shows you how much upside potential this sector has.

Apple TV Seen Driving Cable Broadband Demand

Cable TV companies will have 10 million more broadband subscribers than video customers by the end of 2016, according to a rosy industry report by Moody’s Investors Service, which says an Apple (AAPL) web TV service could further drive demand for cable broadband. Apple is focused on a “broadcast OTT (over the top)” online video service that will raise the bar for live-streaming network requirements. Jason Cuomo, a Moody’s analyst, says cable TV