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High Dividend ETFs - An Equity-Income Investment Fantasy

Submitted by Steve Selengut | RSS Feed | Add Comment | Bookmark Me!

Where's the beef? Where's the high income? Who are they trying to kid?

A week or two ago, while exchanging ideas at an AAII chapter meeting somewhere in the Northeast, a comparison was made between a professionally directed "Market Cycle Investment Management" (MCIM) portfolio and any of several "High Dividend Select" equity ETFs.

Many years ago, I raised the question (to no one in particular): what's better for your financial health, 6% tax free/tax deferred or 3%? There is absolutely not one molecule of similarity between any MCIM portfolio and any Index ETF, period. You decide which is best for you.

I took a closer-than-I-normally-would-bother-to look at three different equity ETFs in the "high dividend equity" category: PFM, FDL, and VIG. They had almost everything in common, except their Morningstar rating, which varied from two-star to five-star. Interestingly, the five-star rated fund seemed to be the most speculative.

Each was constructed, or "marked-to", the weighting of the securities in a specific index, such as the "Dividend Achievers Select Index". These indices are comprised of mostly large capitalization US companies with a history of regular dividend increases.

The ETF owns every security in the underlying index, and it does so absolutely all of the time. There is no thought of profit taking --- and no manager to do it.

Consequently, one would expect that (in addition to replicating the market value of their own index) each ETF's performance would pretty much track that of the NYSE only, dividend paying only, Investment Grade Value Stock only, Investment Grade Value Stock Index (IGVSI).

They didn't do either over the last five years --- actually, none of these ETF securities have been in existence for more than five years and none has surpassed its pre-financial-crisis high. Still, these funds would probably "perform" better cyclically than most open-end mutual funds.

On the other hand, the similarly constructed IGVSI has surpassed its 2007 all time high, and the MCIM portfolios which use it as a "selection universe" have done far better than that.

What's a selection universe? In the ETF case, it's everything in an index at any price, with positions tweaked occasionally to reflect the equities held in the "real" index --- without considering profit or loss. In regular mutual funds, its whatever the boss tells the manager to buy.

An MCIM portfolio manager would "select" from the total universe just those stocks that meet a set of forty-one-year +-tested buying standards for additions to an investment portfolio. He or she would also be taking profits on issues that have met pre-defined selling targets.

That's right, there is never any "smart cash" in an ETF.

Finally, in an MCIM portfolio, there is no need for periodic, market-value-driven, position adjustments because diversification is based on the cost-basis of portfolio holdings. Is it clear that weighted indices have little concern with diversification --- and why should they?

These are not real investment portfolios. They are sector-tracking mechanisms that have been securitized as Wall Street gambling devices. The three ETFs contained 206, 100, and 142 positions, respectively, but each had roughly 50% of the market value in the top 10 holdings.

And who do you think is influencing the fund creator's weighting judgment?

MCIM portfolios never hold even fifty equities (even at the depths of a correction) and individual positions are never allowed to exceed 5% of total portfolio cost basis. Yes, more concentrated while still being well diversified, and managed to take advantage of the different individual price cycles of all qualifying securities.

On the issue of income, where the questioner's position was that these elite dividend producing companies consistently raise their dividends and thus are excellent income providers --- the whole premise is wrong. The purpose of stock ownership is growth production in the form of capital gains --- not income in the form of dividends.

Dividends are a sign of a company that is both strong financially and respectful of the investment made by shareholders --- certainly a less risky class of equities. But there is a whole 'nother family of securities (generally safer and more generous with cash flow than any equity) intended primarily for income production.

The average income of these three ETFs is roughly 2.5% --- probably less than the pre-trading income of just the equity portion of the most aggressive of the three MCIM portfolio asset allocations.

Having a required 30%, 50%, or 70% cost-based asset allocation to income securities (now yielding over 6%) is having a high income portfolio without the added risk of some of the futures speculations that were included in at least one of the ETFs.

These ETFs have a basis in IGVSI quality equities, and could be excellent trading vehicles. Certainly, they can be expected to track the IGVSI and the more popular (but totally manipulated) DJIA and S & P 500 averages.

But traded they must be, or they are just another "buy 'n hold" archaism. ETFs are actually not managed at all. The "passive management" referred to is merely the readjustment of holdings to mirror the weightings in a separate and totally unmanaged index.

MCIM "mirror" portfolios, on the other hand reflect the actual transactions that take place within a totally day-by-day, actively managed portfolio. They produce capital gains in addition to dividends and interest, and assure a steadily growing "base income" in the process.

Market Cycle Investment Management Portfolios are investment portfolios; ETFs in general are derivative gambling devices; High Dividend ETFs are quality-and-income equity derivative gaming devices that could be useful around the bottom of the next correction --- the next prolonged correction, that is.

The investment gods are not happy with ETFs, or with crash-causing derivative products in general --- stocks and bonds (and active management) may not be as cheap or as sexy, but they are far better for your financial health.

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