Not All Dividend ETFs Are Excessively Valued

A frequent criticism of dividend exchange-traded funds this year is that some of these funds expose investors to expensive stocks by way of substantial allocations to defensive sectors such as consumer staples and utilities.

Indeed, investors' thirst for yield and income coupled with still low interest rates has, until recently, been a boon for the consumer staples and utilities sectors. The SPDR S&P Dividend (ETF) (NYSE:SDY), an ETF with a sector lineup that can be considered defensive, is up 14.2 percent year-to-date, including dividends paid. That is better than double the 5.7 percent returned by the S&P 500 over the same period.

Digging Deeper Into SDY

Consumer staples and utilities combine for 25.5 percent of SDY's weight and are the ETF's third- and fourth-largest sector weights, respectively. Still, it might be more accurate to say this and some other dividend ETFs are slightly rather than excessively overvalued.

During the periods of Quantitative Easing II and Quantitative Easing IIIwhen monetary easing suppressed the long-term Treasury yield below the dividend yield for stocksinvestors hunt for yield lifted the valuation of high dividend stocks above its historical average and the spread measure dipped below its five-year average, indicating dividend stocks were slightly overvalued, said State Street Vice President David Mazza in a recent note.

Today, as interest rates once again fall around the globe, the highest dividend yielding stocks are currently trading at their 5-year average spread. The takeaway here is that dividend stocks may be slightly expensive [emphasis omitted] but they do not appear to be excessively overvalued.

SDY only holds stocks that a have a minimum dividend increase streak of 20 years. The ETF's largest sector weight is 16.1 percent to industrials, followed by 15.4 percent to financial services, a sector that has been displaying favorable dividend growth trends for several years. Neither of those sectors are richly valued relative to historical norms. In fact, financials are inexpensive against long-term averages.

A Word On Dividend Growth

Another critical element regarding dividend growth stocks is that these stocks perform notably less poorly during bear markets. According to State Street data, the average drawdown for the S&P 500 during its worst 15 months is almost 7.6 percent, but the average drawdown for SDY's underlying index during those months was less than 5.8 percent.

In this market, where earnings growth has been negative and balance sheet leverage is increasing for S&P 500 stocks, investors should consider favoring dividend growerscompanies that have a long track record of consistently raising their dividendsrather than defaulting to the highest dividend yielders, added Mazza.

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