Ex-Financial Dividend ETF — What’s All the Buzz About?

Given the woes plaguing the global banking sector — among them the never-ending Greek drama and a U.S. mortgage market that refuses to improve — it�s not surprising to see investors fleeing financial stocks. The popular Financial Select Sector SPDR (NYSE:XLF) is down more than 15% in just the past three months alone. Aggressive traders have started to nibble a little at financial stocks, but most conservative investors are still steering clear.

This is particularly obvious by the recent popularity of the WisdomTree Dividend ex-Financials ETF (NYSE:DTN). Forbes reports that the ETF has seen inflows in the past week that have expanded its shares outstanding by nearly 4%.

Dividends are en vogue these days, and with good reason. After a decade in which investors have seen little in the way of capital gains, cash dividends ensure that they see a return that is not entirely dependent on the fickle whims of the market. Moreover, the companies that pay dividends tend to be less volatile than those that do not. And given the paltry yields on offer in the bond market, investors hardly can be blamed for running to high-dividend stocks instead.

WisdomTree�s explicit focus on the absence of financial stocks in DTN is telling. The 2008 meltdown was first and foremost a banking crisis, as is the festering European sovereign debt crisis. Investors want to know that the dividends they depend on are safe. Virtually all banks slashed their dividends during the 2008 crisis, and investors fear it will happen again.

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Alas, I fear that this is another case of closing the barn door after the horse has already bolted. There is little need for an ex-financials dividend ETF because few dividend-focused ETFs have much exposure to the financial sector today. None of the ETFs based on the Mergent Dividend Achievers Methodology — such as the Vanguard Dividend Appreciation ETF (NYSE:VIG) and the PowerShares Dividend Achievers (NYSE:PFM) — have much in the way of financial exposure. Considering that a prerequisite for membership is 10 consecutive years of rising dividends, none of the banks that slashed their payouts in 2008 or 2009 would make the grade. VIG and PFM have 6% and 4% of their respective portfolios in financials.

Similarly, the iShares Dow Jones Select Dividend (NYSE:DVY) — the largest and most widely traded dividend-focused ETF — has only 9% of its portfolio in financials.

It would seem that the ex-financials ETF brings very little new to the table. Still, to give the ex-financials ETF the benefit of the doubt, let�s see how it performed relative to its less restrictive peers during the past three months of intense volatility.

Figure 1 compares DTN�s performance against its sister ETF, the WisdomTree Total Dividend Fund (NYSE:DTD). For all intents and purposes, the index that is used to construct DTN is the index used to construct DTD, minus the financial sector. For good measure, I also included the iShares DVY.

Click to EnlargeFigure 1: DTN vs. DTD vs. DVY, Three Months

The ex-financials ETF has modestly outperformed its broader WisdomTree sister fund, but it traded in virtual lockstep with the iShares DVY. And its outperformance relative to its sister fund is due less to the absence of financials as much as the relative overweighting of defensive sectors like utilities. Utilities make up 18.5% of the ex-financials ETF and only 8.7% of the broader ETF.

OK, perhaps the past three months isn�t a big enough sample set to judge the value of an investment strategy. Let�s try this exercise again, including the meltdown years of 2008 and 2009.

Click to EnlargeFigure 2: DTN vs. DTD vs. DVY, Five Years

Here, the story gets a little more interesting. The iShares DVY started to break down earlier because of its larger holdings of financials. Before the crisis, the financial sector was a large component of DVY. But before the dust finally settled in March of 2009, it didn�t matter much. All three funds bottomed out at comparable lows. The two WisdomTree ETFs traded in lockstep during the subsequent �melt up� from the March 2009 bottom to early 2010 top before the ex-financials began to modestly pull ahead.

What are we to take away from this?

I�ll start with a general observation: There are simply too many ETFs out there. I tip my hat to WisdomTree for blazing new trails with fundamental indexing. This was an exciting area of academic finance a few years ago, and they deserve credit for applying it to the real world of investing.

But there is no reason to have the Dividend ETF (DTD), the ex-financials ETF (DTN) and even the Large Cap Dividend ETF (DLN), which I current use as a proxy for high-quality U.S. equity in the Sizemore Capital Tactical ETF model. Pick one, guys. They�re not different enough to warrant having all three. I could make similar arguments for PowerShares’ suite of dividend ETFs, but I�ll spare readers the rant.

Secondly, when all hell broke loose in 2008, the ex-financials ETF didn�t do materially better than its peers in protecting investors. Not having exposure to the financial sector mattered surprisingly little.

And finally, the rationale for an ex-financials dividend ETF is questionable at best. As I said before, few U.S. financial firms currently meet the criteria to be included in the broader dividend ETFs. Assuming that, with the passage of time, the financial sector warrants membership again, a better approach might be to limit the ETF’s allocation to any one sector, financials or otherwise. Good financial stocks should be included in an investor�s dividend stock portfolio.

Now, as to the question of what qualifies as a �good� financial stock in this environment, that is a different subject for a different article. One thing at a time.

Sizemore Capital currently holds DVY and DLN in client accounts.