Many investors consider dividend ETFs to be safer than growth-oriented stocks. The perceived benefit from a consistent income stream is deemed to be more desirable than just riding out a steep drop without getting paid for the adventure.
Dividend stocks also are considered to be in a more mature phase of their business cycle, which paints them as anchors of stability in a storm of chaos. The fact that they can afford to pay back shareholders from profits must mean that their business models are quite sound.
However, the truth is a little different than theory — the results of backtesting through extreme market conditions seem to uncover a mixed bag in terms of drawdown.
In fact, dividend ETFs can often be just as volatile as a traditional broad-market index.
Dividend ETFs – No Sure Thing
The 2008 financial crisis and 2011 market drops both offered some interesting perspective on risk management — namely, that ETFs dedicated to equity income are not necessarily a safe harbor when volatility ramps up.
As you can see, the Vanguard Dividend Appreciation ETF (VIG) and SPDR S&P Dividend ETF (SDY) had slightly better returns than the market, while the iShares Select Dividend ETF (DVY) actually fell more than its peers. All told, none of these funds outperformed significantly enough to consider them a safer alternative during a period of extreme duress.
Click to Enlarge The 2011 time frame, while albeit a much shallower and quicker drop, yielded similar results. Each of the dividend ETFs traveled a similar course to the broader market with very little differences among the group.
Ultimately these results reinforce the notion that dividend ETFs are not built for defense. Instead, they are a tool to be used for both income and capital appreciation when bullish phases warrant their application.
I harbor no ill will to the aforementioned funds — in fact, I am a big fan of all three dividend ETFs because they have yielded excellent outcomes under the favorable circumstances we have experienced over the last several years.
Granted, there is some embedded selection bias in the time frames used in these drawdown examples. There were periods during 2008 when each of these dividend ETFs were outperforming the market for a short period of time.
However, if risk management is your No. 1 priority, you might need to consider other alternatives during the next corrective phase.
How You Should Prepare for a Correction
The first step I always recommend is for investors to place a trailing stop-loss or other sell discipline on their holdings to guard against a protracted downtrend. That way you can sleep well at night knowing you have a defined exit point for your capital that will always backstop your investment thesis. This is particularly important with the market near all-time highs and having gone several years without testing its long-term moving average.
There also are a variety of other defensive measures you can take to lower the volatility of your portfolio. This might include adjusting your asset allocation to embrace greater exposure to fixed-income or cash in the event that your stop-losses get hit. A mix of Treasury and investment-grade corporate bonds in the Vanguard Intermediate-Term Bond ETF (BIV) could surge significantly on a flight to quality that sends interest rates lower.
Another strategy might entail adding sector-specific themes such as the Consumer Staples SPDR (XLP). This large-cap ETF invests in a variety of consumer goods companies that produce essential products with inelastic demand. Under both time frames that were tested above, XLP produced considerably less drawdown than the broader market.
In addition, there are several ETFs that offer low volatility strategies such as the iShares MSCI U.S. Minimum Volatility ETF (USMV). This fund selects a group of stocks from a diversified index with lower average price fluctuations than their peers. That might translate to a more muted decline that helps minimize peaks and valleys from erratic price swings.
It’s easy to assume that the next correction will be similar to prior events, but I would not bet on a future dip taking a parallel path. Each episode will have its own unique twist, and it will require flexibility for you to navigate unscathed.
Having a disciplined investment approach that incorporates active changes will play a key role in a successful outcome for your portfolio. That might include dividend ETFs — but they shouldn’t be your only tool.
David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. As of this writing, he was long USMV. To get more investor insights from FMD Capital, visit their blog.