It's Getting Pricey To Chase Yield

Defensive sectors come with a price. Literally. Sectors such as consumer staples and utilities are prized by conservative investors for those groups' low beta reputations and above average dividend yields.

However, the usual tradeoff is that to gain those benefits, investors must also embrace valuations that often run well in excess of the broader market. That is currently the case as the combination of still low interest rates in the U.S. and investors' thirst for less volatile asset classes this year is pumping up valuations on defensive groups.

“Dividend stocks, particularly those in more defensive industries, are and have been expensive for some time. This is a function of several trends: a preference for safe, stable companies, the growing popularity of minimum volatility funds and the quest for yield. The last one here should come as no surprise given central banks have anchored short-term interest rates at zero and long-term rates continue to be suppressed by massive asset-purchase programs and the generally sluggish nature of the global recovery,” said BlackRock's Russ Koesterich, head of asset allocation for the BlackRock Global Asset Allocation Fund, in a recent note.

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Indeed, some traditional dividend ETFs are heavily exposed to richly valued sectors. For example, the $15 billion iShares Select Dividend ETF DVY sports a price-to-earnings ratio of almost 19.4. That is likely the result of an almost 31.8 percent weight to utilities stocks, one of the largest such allocations among all ETFs that are not dedicated utilities funds.

Utilities stocks are expensive. In a note out Monday, Goldman Sachs says the sectors trades at a premium to the S&P 500 based on 2017 and 2018 earnings estimates and that utilities' forward price-to-earnings ratio is higher compared to its five-year average. 

DVY yields 3.2 percent. Other dividend ETFs are seen as expensive as well by way of large consumer staples allocations. One this year's best-performing sectors, staples are also seen as richly valued compared to the S&P 500.

For example, the iShares Core High Dividend ETF HDV sports a valuation on par with DVY's thanks in part to an 18.4 percent consumer staples allocation. Investors are getting what they ask for HDV, though. The ETF's three-year standard deviation is less than 10 percent and it yields 3.6 percent.

“First, when considering the valuations on yield names, it is necessary to take into account the overall yield environment. As long as yields remain near historical lows, relative valuations are likely to stay elevated relative to the pre-crisis norm,” adds Koesterich.