SDY: Likely Not Worth The Fee (NYSEARCA:SDY)

Thesis

With a long track record, SPDR® S&P Dividend ETF (NYSEARCA:SDY) is a dividend ETF that has attracted many investors. Although the market has placed significant assets with SDY, its higher fee raises questions on whether investors are getting what they pay for. We go into the details of the index SDY is set to follow to understand what investors are really getting.

Overview

SDY is one of the largest US equity dividend focused ETFs, with a track record that is quickly approaching 20 years. With over $22 billion in assets under management, the ETF offers ultra-high liquidity with a somewhat languishing payout ratio. One of the more attractive empirical features of SDY is the lower beta, providing some additional diversification to broad market exposure. However, the high price tag of 0.35% in fees is eyebrow raising when so many alternatives come with roughly half the cost.

Index Methodology

SDY tracks the S&P High Yield Dividend Aristocrats Index. The index is designed to measure the performance of companies in the S&P 1500 composite that have increased dividends each and every year for the last 20 years. Before diving further into the details behind that methodology, our initial reaction is that this objective is extremely restrictive and may be focusing on a subset of companies that adhere to a very strict dividend policy (likely sacrificing a flexible capital structure in the process).

Universe Construction:

• Must be part of the S&P 1500 Composite

• Market cap of at least $2 billion, current constituents can go as low as $1.5B

• Average daily volume traded of at least $5 million for the prior 3 months

• Must have increased total dividend per share every year for at minimum 20 years

Index Construction:

• No position may exceed 4%

• Positions are weighted by indicated yield, essentially annualized dividend payments per share dividend by the share price

SDY takes a very simplistic approach to selecting the constituents, working under the premise that stocks that have previously increased dividends consistently will continue to do so. A 20-year time requirement for the track record is extensive and likely eliminates a number of potential holdings, as well as introducing sector biases. Additionally, SDY does not make any attempt to identify those that are more likely to increase their dividend distributions by looking at leverage ratios, profitability or other metrics.

Different from many of its contemporaries is the lack of a market cap weighting and instead opting for a dividend yield weighting. But by having such a tight universe selection criteria, it most likely has less of an impact than other more rank-based methodologies such as SCHD.

Portfolio

Breaking down the industry exposure provides supporting evidence to the biases likely introduced by the dividend track record criteria. Technology makes up a nominal position, likely due to both the length of the requirement, many new technology companies didn’t exist or were not making distributions 20 years ago, and due to the fact, they tend to distribute cash back to shareholders via buyback instead.

A nearly 50% weighting towards Industrials, Consumer Defensive and Utilities further shows the alignment to more traditional industries. Additionally, we start to understand why the beta runs below 1 with a very defensive exposure.

Although we always expect sector deviation when comparing a dividend fund to the broader market, SDY further expands on these variances. Investors of SDY must be cautious not to compare to the broad market on a frequent basis, given their portfolios are likely to drive significant differences in short term returns. As investors, it is important to understand our inherent behavioral biases and manage them objectively as best we can. Our view is investors of SDY may subject themselves to such extremes that many will choose to enter/exit at the worst times.

Performance

As expected, some years experience significant differences in performance when contrasting SDY and the broader index as represented by VTI. Overall in the last 10 years, SDY has lagged VTI, producing a total return of 9.67% annualized versus 11.40% for VTI. Years prior to 2014 held similar differences, but at that point in time, the ETFs shared almost an identical performance since SDY’s inception.

Factor Analysis

Although we easily have enough timespan to identify the factor exposure with SDY, unfortunately the model does a relatively poor job of explaining the returns. Certainly it highlights the lower market exposure and as expected we do see a small amount of small cap exposure (unusual for large dividend focused ETFs). Given the industry biases, it is no surprise to see the value risk factor having a material coefficient as well.

Risk Statistics

Although SDY sports a beta factor of just 0.8, this is somewhat understating the true risk. From both a standard deviation (annualized) and a max drawdown perspective, the differences in risk metrics between SDY and broader market are minimal, certainly not what investors would typically hope for investing in an ETF with such a low beta.

Dividend History

SDY has a long and relatively consistent history of increasing dividends. Only 2 of the last 10 years did it not increase in distributions (for this exercise, capital gain distributions have been removed). That being said, as noted in the onset of the analysis, the starting yield is not particularly noteworthy.

Looking at the more recent 5 years, dividends have grown at a rate of 5.6% annually. Given the time period spans pre- and post-covid, it should be a relatively unbiased dataset. All things considered, most dividend investors are likely reasonably pleased by a 5.6% annual growth rate from a broadly diversified ETF. From 2013, SDY took until 2021 to double the annual dividend distribution, 8 years, before slightly slipping below the doubled amount in 2022.

Risks

The largest risk we see with SDY is the extreme sector bias the index methodology introduces. The impact of which could be performance that deviates further from the broader market than investors have the patience to tolerate.

Upside

Investors should be relatively pleased if SDY can continue its track record of growing dividends at a quick pace. Additionally, the more defensive industry exposure certainly has the potential to provide downside protection against some macroeconomic risks.

Conclusion

In our opinion, SDY is a reasonable ETF for those already invested in it (especially those sitting on large capital gains). However, we felt the methodology for identifying dividend growth companies was overly simplistic, lacked any forward-looking measure and introduced too much industry bias. When taking this into account and the fact that the fee structure is the highest when compared to its direct competition, we conclude that investors are likely better off looking at SCHD or DRGO.