“Building a Dividend and Income Portfolio with ETFs” is the title of a presentation I’ve been giving the past couple of years. There are about two dozen ETF categories, encompassing a couple hundred unique funds that could be included in such a portfolio. I highlight the attributes and risks of each category, showing investors why a portfolio approach is the preferred method of targeting this objective. Perhaps some investors can find everything they desire in a single ETF or mutual fund, but they are likely to be the exception.
One of the risks I highlight is the fact that many of these funds have a high degree of sector concentration risk. Many dividend products have overweight concentrations in the Utilities and Telecommunications sectors. That’s fine as long as these two sectors are performing well, which has been the case for most of the past five years. After all, risk is easily tolerated when it doesn’t manifest itself. However, sector concentration risk often goes unnoticed until things turn bad.
Recent market action has been unkind to Utilities and Telecommunications, exposing some of the inherent risks of dividend products. For example, First Trust Morningstar Dividend Leaders (FDL) dropped 4.1% in the last half of May versus just a 1.6% decline for the S&P 500. While certainly not the end of the world for owners of this popular dividend fund, it is enough to warrant a closer look.
First Trust Morningstar Dividend Leaders (FDL) currently has a 26.9% allocation to Utilities and another 18.3% invested in Telecommunications, for a 45.7% combined weighting. For comparison, it is important to note that these two sectors total slightly less than 6% in the S&P 500. In this particular example, the Utilities and Telecommunications sector concentration risk is obvious, with the dividend ETF having 7.6 times the weighting as the S&P 500 benchmark.
Diversification is an important ingredient in any portfolio. When building a dividend and income portfolio, be sure to pay special attention to sector diversification.
Financials climbed two spots to take over the leadership position, a spot it has held off-and-on throughout much of 2013. Consumer Discretionary slipped to second place, relinquishing the first place honors it wrestled away from Financials only a week ago. Industrials improved from fourth to third, although the big news this week is the rise of Technology into the upper half of the Sector rankings. Technology began the year as one of only four Sector categories with negative momentum. It was in last place at the end of January and remained there for most of the three following months. Improvement was the operative word for Technology in May, and it appears to be carrying over to June. Health Care fell from second to fifth, although the top five sectors are now tightly bunched without much separating them. Strength starts to taper off in the lower portion of the rankings where Consumer Staples dropped from sixth to eighth. It, along with three other high yielding groups, became the laggards in recent weeks in the face of rising interest rates. Utilities and Real Estate have now flipped over into negative trends while Telecom appears poised to do the same.
A major shift in strength took place in May and is now complete. A month ago, Mid Caps were at the top of the Style rankings and Small Caps were at the bottom. Today, small capitalization categories along with Micro Cap, the smallest of the small, occupy the top four spots. Micro Cap sits in the top spot followed by Small Cap Growth. The former Mid Cap leaders are now huddled at the bottom. The passage of a month has essentially turned the Style ranking chart on its head. Additionally, the momentum scores are broadening out. There is now a 17-point difference between first and last place. The difference was a mere 6 points four weeks ago. Mid Cap Value, the leader a month ago is now on the bottom. We said the shift is complete, but that is not to imply another shift is imminent. The new regime can potentially remain in place for an extended period.
Despite the recent weakness in domestic stocks, the U.S. held on to its #1 spot in the Global rankings this week. Europe remained in second place while narrowing the gap between it and the U.S. The U.K. improved two spots to third as World Equity and EAFE round out the top five, and those five constitute the only categories with positive momentum scores this week. Canada and Japan both flipped from positive to negative trends. Japan’s fall in the rankings continues this week, dropping from third to sixth. Just two weeks ago, Japan was at the top of the world, but rising bond yields in Japan have called the country’s quantitative easing efforts into question. Weakness is more apparent as we move down the list. Emerging Markets, China, Pacific ex-Japan, and Latin America now have entrenched negative trends. Latin America broke below its November trough and is dangerously close to erasing all of its gains of the past three-and-a-half years.
“The best argument for mutual funds is that they offer safety and diversification. But they don’t necessarily offer safety and diversification.”
Ron Chernow, writer, journalist, historian, and biographert
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