by Charles Sizemore | July 26, 2012 7:45 am
If you’ve been trading or investing long enough, you’ve no doubt come across the “Dogs of the Dow” strategy. In its most popular form, an investor buys the 10 Dow stocks with the highest dividend yield, holds them for a year, then starts the process over again.
The Small Dogs of the Dow uses the same strategy — you find the Dogs of the Dow, then buy the cheapest five. Years ago, The Motley Fool had a different twist. They eliminated the highest-yielding Dow stock in the belief that the cheapest stock might be cheap for a reason, then made an equally weighted portfolio of the next four.
Though the name “Dogs of the Dow” has a nice ring to it, there is nothing particularly unique about this strategy. It is a mechanical value trading strategy designed to find stocks that are temporarily cheap as measured by their dividend yield. Nothing less and nothing more.
Innumerable studies have shown that simple value strategies outperform the market over time. To give two high-profile examples, Ibbotson and Associates and the academic duo of Eugene Fama and Kenneth French did similar studies that found that value stocks, as measured by low price-to-book ratios, outperform growth stocks over the long run. The Dogs of the Dow is just a simple way to implement these insights in a real-world portfolio.
It’s also a rather poor one.
Let’s start with portfolio size. There is absolutely nothing wrong with running a concentrated portfolio if you’ve done your homework and have a high degree of conviction in your investment picks. How do you think Warren Buffett produced those legendary returns of his over the decades? It wasn’t from being a closet indexer.
But in running a mechanical model like the Dogs of the Dow, you’re running a concentrated portfolio without doing any of the research that would make it reasonable. And given that the Dow Industrials have only 30 stocks and very little in the way of sector diversification, you’re starting with a limited pool.
The Dow is a terrible index that is tracked today only because of name recognition and tradition. Were Charles Dow alive and working on Wall Street today, the Dow Jones Industrial Average would not be what he would have come up with. It is a relic of an age before computers, and any professional using it today for anything other than elevator conversation ought to have his licenses revoked and be publicly flogged.
Look at what you would have had to choose from in 2008. The highest Dow yielders going into that year included General Motors (NYSE:GM), Citigroup (NYSE:C), JPMorgan Chase (NYSE:JPM) and General Electric (NYSE:GE). Not exactly what I would have considered a conservative value investor’s dream portfolio given that General Motors went bankrupt and the other three had to seek bailouts.
This brings me to the focus of this article, the ALPS Sector Dividend Dogs ETF (NYSE:SDOG), which began trading late last month.
SDOG takes the spirit of the Dogs of the Dow strategy but addresses its major flaws. Rather than use the Dow as its pool, it uses the much larger S&P 500.
But in my view, the biggest selling point is its sector diversification. SDOG holds the five highest-yielding stocks in each of the S&P 500’s 10 industrial sectors for a total of 50 stocks. In other words, it will hold the five highest-yielding telecom companies, the five highest-yielding consumer discretionary companies, the five highest-yielding financials, etc.
So, rather than get the 50 highest-yielding stocks in the S&P 500, which could be concentrated in a few problem-plagued sectors, your risk is spread evenly across all major sectors. You avoid any sector biases. For a low-maintenance mechanical strategy, this is attractive.
SDOG is too new to have a dividend history, but its underlying index, the S-Network Sector Dividend Dogs Index, has a yield of 5%. Allowing for the 0.4% in management fees that ALPS collects and some amount of slippage would put the ETF’s dividend yield at around 4.5%. That’s higher than the yield on the popular iShares Dow Jones Select Dividend ETF (NYSE:DVY), which yields 3.5%, and more than double the yield of the S&P 500.
A few caveats are in order here. SDOG is a value strategy, and as such it should underperform the market during strong bull markets. Its emphasis also is entirely on current income; there is no screening criteria for dividend sustainability or for dividend growth. This puts it in stark contrast to, say, the Vanguard Dividend Appreciation ETF (NYSE:VIG), which has a low current yield but holds companies with a long history of raising their dividends.
As far as purely mechanical strategies go, I like SDOG as a long-term holding. Its high current yield is attractive, as is its strong value tilt. But for long-term growth, I expect VIG to offer better returns. Investors should be able to find a place for both in a balanced ETF portfolio.
Charles Lewis Sizemore, CFA, is the editor of the Sizemore Investment Letter, and the chief investment officer of investments firm Sizemore Capital Management. Sizemore Capital is long DVY and VIG. Sign up for a FREE copy of his new special report: “Top 3 ETFs for Dividend-Hungry Investors.”
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