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Investing in Dividend Growth for Uncorrelated Returns

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In uncertain markets like today’s, investors are always on the hunt for uncorrelated returns.

This search generally leads investors to a variety of ‘alternative’ products that either utilize a long/short methodology, consider volatility, or invest in a variety of swaps or futures in order to provide a lower risk return that moves independently of the overall market.

Some examples of these strategies include a hedge fund replication with (QAI - Free Report)  or managed futures with , though there are dozens in the overall market. And while there are plenty of choices available in this market today, one that is especially intriguing—and one you might not be too familiar with-- is the Reality Shares DIVS ETF ((DIVY - Free Report) ).

What’s So Special?

This ETF is one of the more unique funds on the market today, and it is one that I think most investors don’t really understand at first glance. Unlike most funds which utilize a long-short strategy or buy up securities in a variety of asset classes, DIVY actually invests in dividend swaps.

A dividend swap looks to isolate the dividend from the rest of the security (also known as ‘isolated dividend growth’), whereby Reality Shares is only betting on the dividend increasing in value, and not the underlying stock. Dividend growth has been pretty stable—besides a few recessionary years—and it moves pretty independently of the actual stock market too.

Think of it as a way to bet that (SPY - Free Report)  or (GE - Free Report)  stock pays $1.00/share in dividends this year, and then $1.05/share the following year. In this scenario, the underlying fluctuations of the S&P 500 or General Electric stock don’t really matter to you; your return is derived from only the growth in dividends.

I like to think of it as analogous to a coupon stripping system which we see in the bond world with Treasury STRIPS. In that system, the bond trades independently of the various coupon payments, much like how in the dividend swap world we see the dividend’s growth isolated from the underlying equity.

Additional Info

While the strategy may be something you aren’t really used to, the technique has provided very uncorrelated returns. According to Reality Shares, it has a correlation below 0.3 with the S&P 500, and a max drawdown lower than, not only the S&P 500, but a bond index that would be the basis for a fund like (AGG - Free Report)  too. And when comparing it to AGG, you’ll note that DIVY definitely holds its own from a performance perspective as well…

Still confused about this unique approach? Well, I recently did an interview with the team at Reality Shares—including Eric Ervin, the President and CEO of the company-- in order to get some additional insights on this dividend swap model, and what this process means for investors. Check it out below for additional information!

 

Eric Dutram: What is ‘isolated dividend growth’ and why should investors know about this concept?

Eric Ervin and the team at Reality Shares: As interest rates dropped to historic lows, investors could no longer rely on bonds, and there was a need for alternative strategies delivering absolute return. This is where ‘isolated dividend growth’ came into the picture.

Isolated dividend growth involves investing in the dividend growth rate of the market while avoiding stock market price exposure/volatility. As an example, an investor could capture the dividend growth rate of all the companies in the S&P 500 at an aggregate level without worrying about whether the individual stock prices go up or down; they are only concerned with whether or not dividends are rising, as that is the primary driver of returns.

The average annual dividend growth rate of the S&P 500 has been approximately 6.5% for the last 44 years (as of 2016), and there have only been three years where dividends were negative during that time. This unique strategy has historically offered low volatility and low correlation to both equity and fixed income strategies.

 

Eric: This is a pretty unique way of looking at the market, how did you come up with the idea?

Reality Shares: Institutional investors have used isolated dividend growth for years as a non-correlated, low volatility alternative asset class, but it wasn’t available to individual investors. We wanted to package this investment opportunity in a transparent, liquid and cost-effective ETF wrapper for the masses, and that’s why we introduced DIVY.

This is the only fund that tracks the index-level dividend growth rate. There are a lot of other dividend-focused ETFs out there, but they tend to have a lot of volatility because they are equity-based. With DIVY, you get bond-like standard deviations but historically, better than average returns. There’s a lot of uncertainty with current economic policies. Dividends tend to be undervalued in the market and DIVY takes advantage of that fact.

 

Eric: What is DIVY actually investing in? The product doesn’t pay dividends, correct?

Reality Shares: DIVY is investing in Dividend Swaps on the S&P 500. The reason for this is that the objective of the fund is to track and deliver the expected growth rate of dividends in the S&P 500 at an aggregate level. Dividend Swaps are used as a proxy for this.

And the fund does not pay out any dividends, that is correct. It is investing in dividend growth only, and isn’t an income destination.

 

Eric: What are the risks for this strategy?

Reality Shares: Every investment strategy has risks, and DIVY is no different. The primary risk associated with DIVY’s underlying strategy stems from potential dividend cuts. In the historically unlikely event where companies in the S&P 500 cut dividends more than they increase dividends (at an aggregate level), DIVY’s return would be negatively impacted.

Other than this, isolated dividend growth has historically weathered most types of interest rate and market environments. To reiterate, while past performance is no guarantee of future results, there have only been three years in the last 44 (as of 2016) where S&P 500 dividends were negative on a net basis. One other risk would be if the market expectation for dividend growth were higher than actual dividends.

 

Eric: How does this fit in a portfolio?

Reality Shares: While DIVY could be a suitable equity allocation alternative, we believe DIVY is a fixed income strategy alternative because it offers low volatility and low correlation to equities and bonds. Think of DIVY as a diversifier for bonds – it can be included in a portfolio for the same reason bonds used to be considered, to reduce risk and to be a safety net. Not only has isolated dividend growth historically delivered low correlation and low drawdowns across a variety of market environments, but the strategy has exhibited a standard deviation similar to fixed income benchmarks.

Since DIVY’s inception (12/18/2014), the S&P 500 has moved 1% or more 125 times (more than 1 out of every 5 days), while isolated dividend growth has moved 1% or more only 15 times. And the current market environment presents the opportunity for DIVY to shine, with both equity and bond markets carrying higher-than-average risk. We believe many of the liquid alternatives out there are really just high-priced T-bills, and for those who feel hedge funds are the traditional diversifier, they have become a lot more correlated to stocks and they are hiding a lot of equity market risk.

Finally, the primary driver of DIVY’s return is growing dividends. If the current administration does enact corporate tax cuts and the proposed one-time repatriation, more cash would ultimately be available for companies to potentially distribute to shareholders in the form of increased dividends.

 

Want to learn more about this topic?

Make sure to listen to our recent podcast with the CEO of Reality Shares where we dive deep into their process and how to find companies that might be growing dividends in the near future. Check out the link below for additional information!

How to Find Stocks Poised to Grow Dividends Now