SPDR S&P Dividend ETF: Is It Worth It? – SPDR S&P Dividend ETF (NYSEARCA:SDY)

Investment Thesis

The SPDR S&P Dividend ETF (SDY) provides income, quality and value: while these features make the fund a great source of cash flow and stability, they also bring the disadvantages of investing in high-yielding securities and using criteria other than market capitalization, i.e. that a risky security may occupy a large position in the portfolio and may be sold at the wrong time. For these reasons, this ETF should be held as a small holding in a portfolio, ancillary to a broader index fund, and not as a core constituent.

The Rational Behind The S&P High Yield Dividend Aristocrats Index

SDY tracks the performance of the S&P High Yield Dividend Aristocrats Index (Source: Morningstar), which includes only companies that are part of the S&P 1500 and that have raised their dividend for at least 20 consecutive years (the lower threshold makes the fund more diversified than the S&P 500 Dividend Aristocrats Index); however, companies are indexed based on their dividend yield rather than market capitalization, with the highest yielding stocks being the largest holdings (though capped at 4%). The main assumption of this ETF is that, if a company with a long history of growing dividends becomes a high-yield dividend stock, it is also undervalued. This has two positive consequences:

• Firstly, the fund has a slightly higher dividend yield than the S&P 500 (2.4% vs 2% based on 2018 dividend); combined with the quality of its portfolio, this makes the ETF suitable for income investors looking for a broad exposure to reliable dividend paying stocks;
• Secondly, because of SDY’s value approach, an investor willing to buy the fund needs to be less concerned about when to buy it; while market timing should not be an investor main concern, we all know the difficulty in handling emotions, like jumping into an investment after its performance has materialized, or waiting for a favorable entry price that might take time to materialize, with the risk of missing out on returns; the value-approach of SDY makes these concerns less relevant.

Downsides

While providing income, stability and even a certain level of growth, SDY also brings downsides, that I would some up in three points:

• Risk of investing in value stocks: buying a business for less than what it is worth is what Benjamin Graham described long ago as the margin of safety, and it is Warren Buffet’s first rule for not losing money; however, value investing carries its own risks and requires careful fundamental analysis; as I mentioned before, the only business fundamental that the fund takes into account is the dividend history, which is a great indicator of quality, but does not assure that the business will remain healthy also in the future: organizing the fund by yield and not market capitalization may increase the risk of investing in less secure stocks;
• Risk of executing at the wrong time: the fund criteria are not based on sectors, but on fundamentals, therefore any company that would raise its dividend for its 20^th year would be bought into the fund, whereas any that would cut the dividend would be sold. In the article “Requiem For Fallen Dividend Aristocrats”, the author shows that, of the dividend aristocrats that cut their dividend in the wake of the 2008 financial crisis, almost 50% have subsequently outperformed, matched or closely followed the market; value investing requires patience, and selling a quality security at the peak of its difficulties, therefore at a depressed price, may contradict the value purpose of the fund;
• Risk of missing out on growth: a typical disadvantage of investing in stocks with a long-term record of dividend payments is buying a business when most of its growth has already happened; this applies to any dividend investing strategy, so nothing new here; I would say that it is the price to pay for stability, yet it is also a risk that investors should consider.

Performance: SDY vs S&P 500

When compared to the S&P 500, the 10-year (as of today) price performance of the SPDR S&P Dividend ETF should not come as surprise, as the latter lacks the technology companies that propelled the growth of the American flagship index.

Source: Morningstar

However, when dividends are taken into account, the picture becomes more benevolent for SDY, as the power of its dividends boosts its average yearly total return to 13.5%, slightly less than the 13.76% provided by the S&P 500 (source: dqydj.com), as SDY’s higher fees of 0.35% bite into its performance. Nonetheless, a dividend investor should be happy of the result, considering the higher and more stable dividend income from SDY.

The European Case: Euro Dividend Aristocrats vs Euro Stoxx 600

For dividend investors willing to invest in Europe’s dividend paying stocks, there is a compelling alternative called the SPDR S&P Euro High Yield Dividend Aristocrats ETF, also made by State Street. Similarly to SDY, the European ETF holds 40 Euro-area stocks that have raised or not cut their dividends for at least 10 years, and weight them based on their dividend yield (highest to lowest) rather than market capitalization.

While having a more lenient threshold than the American counterpart, this European ETF has outperformed the Euro Stoxx 600 since its introduction, and provides a high, growing dividend yield of around 3% (based on 2018 distributions).

Source: Morningstar

How come? I see three possible explanations:

• Lack of technology: of the 10 first constituents of the Euro Stoxx 600, only one belongs to the technology sector, and it does not even make it to the top 5; Europe just did not have the technological disruption that occurred in the U.S., with the consequence that stable, reliable companies continue to dominate;
• Slow growth: after the 2008 financial crisis, Europe has gone through the Euro crisis, and after that the recovery has been sluggish and marred by political uncertainty; in such an environment, it is not surprising that investors tend to favor businesses with dependable returns;
• Higher fees: most of the ETFs based on the broad European Euro Stoxx 600 index come with average fees of 0.20%, which is almost three times as much as the ones you would be charged by holding an S&P 500 ETF, and are not so distant from the 0.30% fees charged on the Euro High Yield Dividend Aristocrats ETF; therefore, the fee-advantage of a broad market American ETF is less relevant in the European case.

The Bottom Line

Stocks with a long record of dividend payments offer decent levels of current income and offer stability when the economy struggles; the S&P High Yield Dividend Aristocrats ETF seeks to provide additional income by investing in undervalued, quality dividend-paying stocks. While the strategy seems to have worked well in Europe due to the perpetual malaise afflicting the Old Continent, it still does not provide better returns than the S&P 500, and investors should be aware of the risks of a standardized value investing approach, i.e. based on few, if not one only, fundamentals. Nevertheless, income investors should consider SDY for its higher level of income and stability, but as a small, satellite holding to a broader index fund.

Disclosure: I am/we are long SDY, SPEUHDAN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.