2020 was a challenging year for many segments of the market, and particularly unkind to dividend investments.
Looking at the past 2.25 years—a telling time that includes the peak earnings point for the broader market—you can see that the average dividend investment (funds and ETFs within Morningstar’s Equity Income category and that carry “dividend” in their name), fell well short of the popular benchmark indices.
*Annualized standardized deviation figures vary based on investment participation. The above chart assumes investment throughout the duration of the sample timeframe.
What Caused Dividend Underperformance in 2020
Often, dividend indices will have a heavy representation in two segments that are vulnerable to weak-market underperformance. The first is companies that have shrunk from their dividend. This means companies with a high dividend yield due to a deteriorating business. While the dividend will inevitably get cut, these companies display a near-term, misleadingly high dividend yield.
The second segment is companies that are highly leveraged. These companies carry more debt, and again, tend to underperform in weaker markets.
High exposure to these segments, paired with a declining market and subsequent recession set the stage for underperformance in the dividend universe.
Actions We Took to Reduce Downside Risk in our High Dividend Growth ETF
Our approach in the AAMA High Dividend Growth ETF has been to combine ETFs that are based on dividend indices that have historically indicated relative strength in the market environment we identify. We then round out the portfolio with sector funds that represent lower historical volatility, and that also line up with our general sector valuation work.
At the beginning of 2020 we owned two dividend ETFs. One of these did poorly in the decline and initial rebound. This ETF was clearly dominated by dividend shrinkers and more leveraged companies. We sold it in April. The second did relatively well and remains in the portfolio.
In terms of sector exposure, we have liked technology and have included a technology dividend fund that filters tech stocks with certain dividend screens. This holding has been gradually pared back as the technology sector has become increasingly over-valued and more volatile. With this update, we adjusted our broader sector ETF allocations to align with our valuation and volatility convictions.
Additionally, in April we added a 10% allocation to preferred stocks. These holdings have reduced volatility in the portfolio. Given that preferred stock ETFs are heavily dominated by bank issues, we do not expect to increase this allocation.
AAMA High Dividend Growth ETF Management Recap:
- Elimination of an underperforming dividend ETF, which was dominated by dividend shrinkers and highly leveraged companies.
- Pared back technology sector exposure, realigning our sector ETF allocations.
- Added a 10% exposure to preferred stocks.
2020 Performance Snapshot
What to Expect from Dividend Portfolios in 2021
In 2021, we expect dividend portfolios that are properly positioned away from dividend shrinkers and highly leveraged companies to perform as expected.
During 2020’s first quarter market decline, futures for the S&P 500 dividend dropped from a high of $61.50 to a low of $40. The current 2021 dividend future for the June contract is currently trading at $62.05. This tells us that dividend expectations are stabilizing. Earnings for 2021, which will be the ultimate driver of dividend trends, are still unfolding (though early Q4 2020 reports have been relatively positive). To date, dividend cuts have been concentrated in capital intensive and travel industries.
While the future looks relatively bright, there are a few factors to keep tabs on as we progress through 2021:
The Impact of Tax Policy Change
With Democratic control solidified, it’s safe to expect tax increases in 2021. However, the overall impact of a tax increase will be relatively small. For example, say the tax rate of capital gains is increased from 15% to 35%. That sounds significant, but on a 2% dividend the investor would see a decline in “take home” gains of just 40 bps (down from 1.70% to 1.30%).
With the impact of tax changes being minimal, absolute and relative performance of principal should be emphasized.
Potential Trouble in Financials
With a democratic majority in the senate, we expect to see increased scrutiny and regulation of the big banks (a large sector of the dividend universe), and subsequent lower earnings. This will likely result in slashed dividends.
Review your dividend portfolio’s exposure to financials. Our High Dividend Growth portfolio has a modest 3.5% allocation to financials (not including preferred holdings, which should be less impacted). We will monitor the developments and manage accordingly.
An over-exposure to financials, which isn’t uncommon in dividend portfolios, could be vulnerable in a unified democratic government.
2020 delivered a wild ride for dividends. And while there are certainly challenges ahead in 2021, the overall environment for dividend funds/ETFs is brightening.
For investors that require consistent, growing income generation we believe dividend portfolios are still relevant in 2021.
Key Considerations for Dividend Success in 2021:
- Find a portfolio that is fundamentally sounds, taking into account widespread sector overvaluation and volatility risks.
- Seek dividend investments that prioritize a consistently growing dividend, not just a high one. This will help mitigate the risk of deteriorating companies that are shrinking from their dividend.
- Keep a pulse on your dividend portfolio’s exposure to the financial sector, which may face headwinds under the new political environment.
The information and opinions in this report have been prepared by the investment staff of Advanced Asset Management Advisors (AAMA). This report is based upon information available to the public. The information herein is believed to be reliable and has been obtained from sources believed to be reliable, but AAMA makes no representation as to the accuracy or completeness of such information. Opinions, estimates and projections in this report constitute AAMA’s judgment and are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as a recommendation to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction in which such an offer or solicitation would violate applicable laws or regulations.
Stay Up to Date
Want to stay up to date with fundamentally-driven market insight, economic analysis, and practice management advice?
Sign up to receive regular roundups of our content, delivered conveniently to your inbox.