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Inner Circle members often ask us about themed ETF investing strategies, and most of the time, we tell them we do not recommend investing in themes.
For example, some ETFs out there are based on the so-called “Dogs of the Dow” stocks. Essentially, the “Dogs of the Dow” ETF is based on a collection of the lowest-priced, highest dividend yielding stocks that trade on the Dow Jones Industrial Average and are updated yearly.
Rising interest rates will work against Dogs of the Dow ETF investing approach
The ALPS Sector Dividend Dogs ETF (symbol SDOG on New York; www. alpssectordividenddogs.com), is an example of an ETF that applies the “Dogs of the Dow” theory on a sector-by-sector basis using the stocks in the S&P 500.
As we mentioned above, the Dogs of the Dow approach involves buying the lowest-priced, highest-yielding stocks in the Dow Jones Industrial Average. At the end of each year, you pick the 10 stocks from the 30-stock Dow with the highest dividend yields. You then invest an equal dollar amount in each, hold them for one year and repeat these steps annually.
The ALPS Sector Dividend Dogs ETF picks five stocks from each of the 10 sectors as defined by the S&P 500 index—consumer discretionary, consumer staples, energy, financials, healthcare, industrials, information technology, materials, telecommunication services and utilities. The ETF picks the stocks with the highest dividend yields. Each holding is then equally weighted so that every company has a similar influence on the ETF’s total return. The end result is a portfolio of 50 large-cap stocks.
The Dogs of the Dow strategy worked well in the 1990s because interest rates were going down. This tended to raise all stock prices. But high-yielding stocks were affected more than most, because they attracted former bond investors who were switching into stocks.
Interest rates are now likely to remain steady, or they could creep upward. So we see little appeal in a Dogs of the Dow approach.
For that matter, we see little appeal in following any formulaic approach to investing. The one basic rule about things like this is that if it sounds too good to be true, then it isn’t true.
The ALPS Sector Dividend Dogs ETF holds a number of stocks we recommend in Wall Street Stock Forecaster (including McDonald’s, Kraft Foods Group, Wells Fargo & Co., Baxter International, Pfizer, General Electric and Intel). It also holds a lot of stocks we don’t recommend. But, more to the point, we don’t recommend using a Dogs of the Dow approach to picking stocks or ETF investing.
There is no “philosopher’s stone”
In the Middle Ages, people used to dream about getting rich by uncovering something called “the philosopher’s stone”—a legendary material that could “transmute” base metals like copper or lead into gold.
Nowadays, investors dream about getting rich by uncovering the ultimate stock market indicator, or what you might call a “magic key to market profit.” This legendary device tells you which stocks to buy and/or how to buy at the bottom and sell at the top.
Promoters sometimes package a magic key into a set of books, videos or a computer program and sell them for hundreds or thousands of dollars. The Internet is full of offers of tools or indicators that supposedly tell you what stock (or foreign currency, or futures contracts) to buy or sell.
The web page promoting the method usually shows how much money you’d have made if you had followed the rule. It may calculate results that stretch back a year or two, or as much as 50 years or more.
The problem is that these “magic keys” reflect what you might call statistical correlations or anomalies, rather than cause-and-effect relationships. That is what we see in this ETF investing approach.
Three tips for ETF investing
- Get out of “theme” ETF investing, like Dogs of the Dow, especially when the ETF’s theme seems to be plucked from recent headlines.
It pays to stay out of narrow-focus, faddish funds, all the more so if they’ve come to market when the fad dominates the financial headlines.
Theme funds like these face a double disadvantage, because they appeal to impulsive investors who pour their money in just as the fad hits its peak. This forces the manager to pay top prices —perhaps to bid prices higher than they’d otherwise go—even if this goes against their better judgment. These same investors are also apt to flee when prices hit their lows, forcing the mutual fund manager to sell at the bottom and lowering the ETF’s performance. But when a fad dies out, as they all do, the fund’s liquidity dies out with it. The manager may have to dump the mutual fund’s holdings when demand is at its weakest, forcing prices lower than they would otherwise go.
- Get out of bond ETF investing.
Many bond funds built great performance records a few years ago. But this was a function of the trend in interest rates; when rates fall, bond prices go up. Interest rates are low right now, but could move upward over the next few years as the economy recovers or in response to inflation fears. This is another way of saying that bond prices could fall.
When bonds yielded 10%, perhaps it made some sense to buy bond funds and pay a yearly MER of, say, 2%. Now that bond yields are down closer to 4%, it makes a lot less sense, and has a greater impact on your ETF’s performance.
The bond market is highly efficient, and we doubt that any bond ETF’s performance can add enough to offset its management fees. In addition, investing in a bond mutual fund exposes you to the risk that the manager will gamble in the bond market and lose money.
Bonds are attractive for predictable income, and as an offset to the stocks in your portfolio. But it’s cheaper to buy bonds directly than to do so through a bond mutual fund. If you want capital gains, buy stocks or stock-market mutual funds or ETFs.
- Get rid of ETFs that show wide disparities between the ETF’s portfolio and the investments that the sales literature describes.
Many ETF operators describe their investing style in vague terms. It’s often hard to find out much about who is making the decisions, what sort of record they have, and what sort of investing they prefer. We always take a close look at an ETF’s performance and investments to see if they differ from what the prospectus or sales literature would lead investors to expect. For example, it may suggest broad diversification, but it may in fact hold a disproportionate amount of mining stocks. Our advice: When an ETF takes on a lot more risk than you’d expect, you should get out.
Have you used a specific ETF strategy in your portfolio? Where they themed-based? Share your experience with us in the comments.
Pat McKeough has been one of Canada’s most respected investment advisors for over three decades. He is the founder and senior editor of TSI Network and the founder of Successful Investor Wealth Management. He is also the author of several acclaimed investment books. This post originally appeared at TSINetwork.ca here, and is republished with permission.
