Most of these funds make great long-term core holdings for just about any investor. However, I get a little leery of funds that appear to be pushing their luck with respect to risk and valuation in the pursuit of higher yields. Right now, the iShares Select Dividend ETF (NYSE:DVY) is giving me reason for pause due to its significant allocation to utility stocks.
Dividend stocks have done especially well lately thanks to the low rate environment. With most fixed income products paying very little, investors have started using dividend stocks as the new quasi-fixed income part of their portfolio. That led to strong returns for conservative income stocks from sectors like utilities and consumer staples but it looks like tailwinds may start turning into headwinds.
Utility yields look enticing when Treasuries are yielding under 2% but look less so when the yield gap starts closing. That’s already starting to happen as the market appears to be preparing itself for what feels like an imminent rate if not at the December Fed meeting then soon in 2017. Since July 1st, the 10 year Treasury yield has jumped from just under 1.4% to around 1.8%. Utility stocks have responded accordingly with the Utilities Select Sector SPDR ETF (NYSE:XLU) dropping 7% since the beginning of the 3rd quarter compared to a gain of 2% in the S&P 500 (NYSE:SPY).
Adding fuel to the fire is the relative valuation of the sector. Utilities have steadily become more and more expensive for much of the last decade. At the end of the financial crisis in 2009, the utilities sector had a forward P/E multiple of 10. Today, it sits at 17. That tops even the broader S&P 500 which is currently just over 16. That is rarely the case and has only happened twice in the past 20 years – once during the financial crisis when investors bailed on anything risky and again during the current bull market.
The iShares Select Dividend ETF currently has about 30% of its assets invested in utilities. Of its major large cap dividend ETF counterparts, the SPDR S&P Dividend ETF (NYSE:SDY) has the next largest allocation to utilities at just 12%. Most others are at well under 10%. The Schwab U.S. Dividend Equity ETF (NYSE:SCHD) has next to nothing invested in utilities.
That’s not to say that the Select Dividend ETF is in imminent danger. If wage growth remains weak or some other unforeseen economic event occurs that causes the Fed to fail to raise rates as expected, utilities could garner renewed investor interest. But having nearly one-third of the portfolio invested in an area that’s pretty richly valued and would likely be negatively impacted by the impending rate hikes, it’s enough to give investors reason to potentially seek out another dividend equity ETF alternative. Its 0.39% expense ratio, one of the highest in the category, is another cause for concern.
The Select Dividend ETF remains a solid long-term buy. In the short term, income seekers may find better options elsewhere.
David Dierking is a freelance writer focusing primarily on ETFs, mutual funds, dividend income strategies and retirement planning. He has spent more than 20 years in the financial services industry and his background includes experience in investment management, portfolio analytics and asset/liability management at both BMO Financial Group and Strong Capital Management.
He has written for Seeking Alpha, Motley Fool, ETF Trends and Investopedia and was also included in the panel for ETFReference.com’s “101 ETF Investing Tips from the Experts”. He has a B.A. in Finance from Michigan State University and lives in Wisconsin with his wife and two daughters.