Many equity income-focused indexes suffer from a single-minded focus on generating the highest yield, without necessarily looking at the consequences of how its underlying benchmark may be concentrated at the sector levels. Unfortunately, due to their construction rules, these indexes tend to “double down” when a certain sector exhibits strong economic performance. Then, if the sector runs into economic challenges, these same construction rules force investors following the benchmark to have to sell at the bottom.
To take one example, the Dow Jones U.S. Select Dividend Index rules first apply quality screens to the investable universe. Then, at each re-constitution, these screens effectively remove stocks with low dividend growth rates, low dividend payouts, or low liquidity. To be included, companies are required to have made dividend payments in each of the previous five years and have a non-negative trailing 12-month earnings-per-share. The rules in and of themselves sound sensible, but the inflexible reconstitutions can cause a disadvantageous trading pattern over time.
Concentration over time
Our chart shows the sector composition of the Dow Jones U.S. Select Dividend Index over the past thirteen years. Heading into the financial crisis of 2008, the benchmark held a weight of 40-50% the financial sector, due to the attractive yield and dividend growth characteristics of those companies.
Dow Jones US Select Dividend Index, Sector holdings, 2005 - 2014
However, as the financial crisis unfolded in 2008-2009, many of the companies in the financial sector were no longer able to meet the quality screens. So they were dropped due to a lack of growth in dividends, or even a suspension in dividends due to capital restrictions tied to government bailout programs. Exposure to the financial sector contracted significantly over the next three quarters, to just over a weight of 10% weight.
Impact of concentration
Where did this leave equity income investors? Well, they captured the downside of the concentration in financials, but because of the built-in quality screens, they were “forced” to sell out of these securities before they could recover. Equally important, they essentially traded one concentration for another. Post 2008, a persistent concentration in utilities was introduced, at approximately a 30% weight. While this is not concerning at the moments, what if utilities companies see, for example, regulatory reform affecting their ability to pay dividends. Well, investors could follow a similar trajectory to that of the financial sector in 2008.
The bottom line
The construction of the equity income benchmarks upon which ETFs are based can have unforeseen consequences. Concentration at the sector level, paired with various entry criteria can effectively force an index to sell at a disadvantageous manner. Said another way -- having concentrations in your index is bad because they expose you to bubbles, but they’re even worse if the index has to sell at the bottom of the market.
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Alex Paulsen, Director of Research
Alex is responsible for supporting new product research and development initiatives as well as all aspects of dividend equity and closed-end fund strategies. Prior to joining Parametric in 2012, he worked at BlackRock Alternative Advisors, the Fund of Hedge Funds unit of BlackRock, executing hedge fund investment reviews as well as ongoing risk management efforts for long/short equity and equity-related hedge fund strategies. Alex earned an MS in management and regulation of risk from the London School of Economics and Political Science as well as a BS in economics from the University of Washington.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.