Some Dividend ETFs Prove Sturdy As Rates Rise

Rising interest rates have had the predictable consequence of weighing on an array of income-generating asset classes and sectors, including MLPs and REITs.

At the sector level, those vulnerable to soaring Treasury yields include consumer staples, telecom and utilities.

Although 10-year Treasury yields have slumped 3.2 percent in the past five days, those yields are still higher by nearly 33 percent over the past 90 days. Hovering around 2.84 percent, 10-year Treasury yields are now higher than some marquee dividend ETFs, including the Vanguard Dividend Appreciation ETF (NYSE:VIG).

"Starting in May this year, longer-term interest rates in the U.S. rose considerably on just a hint the Fed could begin tapering its bond purchases later in the year. Between May 1 and August 20, 2013, the 10-Year Treasury yield increased 118 basis points to 2.81%," said WisdomTree Research Director Jeremy Schwartz in a new research note.

Dividend ETFs with exposure to rate sensitive sectors, such as staples and utilities, are prized by investors for relatively low betas and steadily increasing payouts. However, ETFs that emphasize backward-looking dividend increase streaks could be stung if rates climb higher due to their exposure to rate-sensitive sectors and lack of exposure to recent dividend growers that hail from sectors that historically prove sturdy in rising rate environments.

"Looking at specific sectors across the indexes, we see vastly different constituent performance, which is largely a result of selection methodology. A closer look at the Consumer Discretionary sector reveals how the WT SmallCap Earnings and WT U.S. Dividend Growth Indexes outperformed the Morningstar Dividend Yield Focus Index by 19.1% and 8.9%, respectively, from a stock selection basis,"said Schwartz in the note.

ETFs that have held up well in the face of rising rates include the newly minted WisdomTree U.S. Dividend Growth Fund (NASDAQ:DGRW). DGRW debuted on May 22, the exact day when Federal Reserve tapering chatter started, causing a significant spike in 10-year yields in the process. Still, DGRW is up nearly three percent since its debut, indicating that its emphasis on a new generation of dividend growers can benefit investors even as rates rise.

DGRW has no exposure to telecom and utilities shares. However, the fund allocates over 60 percent of its combined weight to the industrial, technology and consumer discretionary sectors. Discretionary and industrial names are, on a historical basis, the top-performing sectors during rise rate environments.

Schwartz notes the benefits of investing in cyclical sectors, which because of lower yields, are often under-weighted in some dividend ETFs.

"These sectors are usually tied more closely to economic growth and tend to perform well when the economy is growing or expectations are improving. Cyclical sectors are characteristically some of the lower-yielding sectors, and indexes that select based on dividend yield are typically under-weight in these sectors compared to the broad market," he said.

Technology is now the largest dividend-paying sector in the U.S. in dollar terms. DGRW has three tech names among its top-10 holdings Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT) and Intel (NASDAQ:INTC).

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Disclosure: Author is long DGRW.