Thesis Summary

Interest rates across the curve are set to remain lower for longer. This will pressure the profitability of several kinds of financials, especially banks. The WisdomTree U.S. Dividend Ex-Financials ETF (DTN) is a good option for dividend investors who want to avoid the financials sector.

Full Investment Thesis

Massive buildups of unproductive debt, diminishing real investment, and expanding inequality have historically led to lower, rather than higher, economic growth and interest rates in the United States.

That is my observation in “The Monetary Death Spiral Is Accelerating,” in which I explain the economic rationale behind this observation. And this time is not different. The huge amount of fiscal spending will further lower the productivity of the debt (as measured by the additional amount of GDP per unit of new debt), weigh on real investment and income growth, and lead to further risk-taking by yield-starved savers.

Low interest rates across the curve are especially bad for business models that borrow short (or accept demand deposits) to lend long. Banks are an obvious example, but so are insurance companies and annuities providers that have promised to pay out a set amount of benefits based partially on investment returns from a fixed income portfolio that may no longer be attainable. Companies employing these business models fall overwhelmingly in the financials sector.

That spells trouble for dividend ETF investors, as many popular ETFs in this space hold a large percentage of financials. Consider the Vanguard High Dividend Yield ETF (VYM), with a 16% allocation to financials. Or the Vanguard International High Dividend Yield ETF (VYMI) at 31% financials. Or the iShares Select Dividend ETF (DVY) at 14% financials. Or the iShares International Select Dividend ETF (IDV) at a whopping 38.5% financials.

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That’s where DTN comes in with its zero percent of financials. If one had bought DTN, VYM, and DVY at the market bottom in March 2009 and held to today, DTN would have slightly edged out the others.

ChartData by YCharts

If my thesis of extended low interest rates plays out, I would expect DTN to outperform its peers even more going forward.

Portfolio Characteristics

DTN’s portfolio is built upon the research of Wharton professor Jeremy Siegel, who demonstrated the long-term risk-adjusted outperformance of steadily dividend-paying and -growing, large-cap stocks over other types of stocks. The methodology first narrows down the potential universe of stocks by market capitalization and liquidity. And, of course, only dividend payers are considered. Then, rather than weight by market cap, the fund weights by yield, which diversifies the sectoral allocations more than a market cap-weighted strategy would.

Notice, for instance, that the typically higher-yielding sectors of utilities and real estate have substantial allocations in the portfolio, which is well-diversified across multiple sectors.

Source: DTN Q1 Factsheet

DTN is also very defensive in nature, with the top five sectors (all defensive in a pandemic economy) representing 60.7% of the total portfolio. At least, that was the case back at the end of March. Since then, Energy has rebounded to take Information Technology’s place in the top five.

However, one thing to point out is that the portfolio is rebalanced only once a year compared to the more common quarterly or biannual rebalance. That allows the best-performing stocks to rise in the percentage weightings over time before the next rebalance. Even so, the highest-yielding stocks still maintain an advantage over the higher market cap/lower-yielding names in the fund.

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As of March 31st, the top 10 holdings included some quite high-yielding stocks:

Source: DTN Q1 Factsheet

Even after a strong rebound in the stock market, these names still sport some of the highest yields among large and mid cap, relatively safe stocks. But since March 31st, we can see that some of the best-performing names have surged upward, shifting the composition of the top 10:

Source: WisdomTree DTN Page

Despite being yield-focused, DTN manages to pick some of the highest quality dividend payers on the market.

The expense ratio is a moderate 0.38%.

The Dividend

DTN pays monthly dividends. Considering dividends over the past 12 months, the current TTM dividend yield is 4.02%. However, this May’s dividend payout of 20 cents is one-third lower than May 2019’s 30 cents. This April’s payout of $0.135 is 29% lower than April 2019’s $0.19. Assuming DTN’s annual payout falls 20% in 2020, the forward dividend yield would actually be 3.22%.

From 2007 to 2008, DTN’s annual dividend fell 27.4%, but considering the portfolio’s defensive tilt, I think it’s safe to assume only a 20% annual dividend drop from 2019 to 2020.

From 2009 to 2019, DTN’s dividend growth came in right around 8% per year on average. Assuming the same dividend growth over the next 10 years, buying in at today’s 3.22% (forward) yield would result in a 10-year yield-on-cost of 6.95%. That’s not bad, but it’s slightly under my target of 7% 10-year YoC for conservative dividend growth investments.

What if one bought the ETF at $73 per share (forward yield of 3.3%)? Assuming the same annual dividend growth of 8%, buying at that price would render a 10-year YoC of 7.12%. My maximum buy-in price then would fall around $73.50 per share.

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As I perused the holdings of DTN, it struck me that the portfolio is very similar to what I would make from scratch today, if I needed to. It has a defensive and above-average yield tilt, and it includes a significant allocation to my favorite sector of real estate. Most importantly, it excludes financials, which would suffer in a prolonged environment of interest rates hovering just above zero across the curve.

As the stock market begins to reflect the decidedly more somber economic reality and the Federal Reserve’s liquidity injections slow, stocks could continue their recent pullback. If so, then DTN will be one of the primary ETFs I will be looking to buy in my Roth IRA.

Disclosure: I am/we are long DTN, VYM. 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.