Rising 10-Year Yields Could Crush Popular Dividend ETFs

Seduced by backward-looking dividend increase streaks, investors have fallen in love with dividend ETFs such as the Vanguard Dividend Appreciation ETF VIG and the SPDR S&P Dividend ETF SDY.

VIG is the largest U.S. dividend ETF by assets and SDY does battle with the iShares Dow Jones Select Dividend Index Fund DVY for the number two spot.

To become part of VIG's lineup, companies must have dividend increase streaks of at least 10 years. For SDY, the streak must be 25 years. Despite the fact that it has been proven there are other ways to find dividend growth and stellar performances among dividend ETFs, investors still lover SDY and VIG. The two ETFs have garnered over $3.3 billion in news assets this year.

Rising 10-year Treasury yields could rain on that parade. While there is no such thing as a risk-free investment, PIMCO's Bill Gross recently said as much, the perception is that U.S. Treasurys are less risky than stocks. Yields on 10-year Treasurys spiked above 2.5 percent earlier Friday and that could be a cause for concern for VIG and SDY shareholders.

Simple math could hammer these ETFs on multiple fronts. The trailing 12-month yield on VIG is 2.17 percent, according to Yahoo Finance. SDY's is 2.15 percent, according to issuer data. In an effort to be generous, we can point to SDY's 30-day SEC yield of 2.43 percent, but we still arrive at a number that is currently below the yield on 10-year Treasurys.

So in order to keep their exposure to stocks that have raised their dividends in the past with no guarantees of future increases, could opt to remain in two dividend ETFs that now feature trailing 12-month yields that both more than 30 basis points below 10-year Treasurys.

"But I want to stay in stocks," says Bob, the avid income investor. Fair enough, but along those lines it must be noted that the PowerShares S&P 500 Low Volatility Portfolio SPLV now features a trailing 12-month yield that is 80 basis points higher than VIG's and a 30-day SEC yield that is more than 50 basis points higher than SDY's, according to PowerShares data.

These ETFs Top Treasury Yields
To be fair, it is understandable why investors have been infatuated with VIG and SDY. The dividend increase streaks imply some level of safety and both ETFs are chock full of familiar blue chips such as AT&T T, Johnson & Johnson JNJ and Procter & Gamble PG. Additionally,
it should be ignored that both ETFs have returned over 49 percent in the three years dating back to June 18, 2010.

On the other hand, VIG is heavy on staples stocks while SDY devotes a combined 27 percent of its weight to the staples and utilities sectors, two industry groups that are richly valued. So not only would a new investor to these funds be sacrificing yield relative to 10-year Treasurys, that investor would also be paying up for past dividend growth. Not to mention the problematic utilities exposure should interest rates rise in earnest.

Investors can and should do better. Again, VIG and SDY are fine ETFs. The point here is not to offend their issuers or investors that own those funds. However, the reality is that yields on those ETFs are now piddly compared to almost risk-free asset.

The WisdomTree Equity Income Fund DHS is one alternative. DHS has $694.1 million in assets under management, or not even 70 percent of the assets SDY has attracted this year. More importantly, the fund's 30-day SEC yield is 3.61 percent and the distribution yield is 3.32 percent, well ahead of 10-years, according to WisdomTree data.

DHS does not focus on dividend increase streaks. Rather it tracks a index that "is dividend weighted annually to reflect the proportionate share of the aggregate cash dividends each component company is projected to pay in the coming year." The result is 64.2 percent three-year gain, massive out-performance of SDY and VIG.

The WisdomTree Dividend ex-Financials Fund DTN is another option to consider. Although DTN obviously lacks exposure to the financial services sector, a group that has grown its dividends in recent years, the ETF has shown decent dividend growth since the financial crisis.

Additionally, DTN is chock full of U.S. large-caps. The ETF's underlying index has had a beta of just 0.78 and annualized volatility of less than 12.3 percent since inception. The 30-day SEC yield is 3.3 percent and the distribution yield is just over three percent. DTN's three-year return is 63.4 percent.

One final thought: It is not unreasonable to say income investors like regular income. DHS and DTN pay monthly dividends. VIG and SDY pay quarterly.

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