By Trevor Hunnicutt
NEW YORK (Reuters) - A U.S. exchange-traded fund with an innovative strategy is sticking to its bet the music will stop for some dividend-paying companies, even as its own performance has the tempo of a funeral dirge.
The Reality Shares DIVCON Dividend Defender ETF buys companies it predicts could hike their dividends and bets against – or shorts – cash-strapped firms that could cut such payouts.
The fund is not managed by a stockpicker. Instead, it is part of a fast-growing group of index funds that rely on algorithms that decide what to buy and when.
With bond yields at historic lows, investors have flocked to stock dividends for income, but DFND's manager is warning investors that buying companies for their dividends without paying attention to their quality cannot work forever.
Seven pieces of data tell the fund whether a dividend-paying company is spinning toward the drain.
For instance, a company with negative free cash flow could be forced to cut its dividend because it is burning money. By contrast, a company with strong earnings growth and a share buyback program might have good prospects and the cash to beef up dividends.
The ETF buys the companies that rank highest on these metrics and shorts those doing the worst, a strategy the fund's issuer calls "long quality and short crap."
Despite the financial engineering, the fund has trailed the S&P 500 every month since its January launch.
"Sometimes the crap tends to rally because that's what everyone wants," said Eric Ervin, Chief Executive of San Diego, California-based Reality Shares Inc, the fund's promoter.
High-income-generating stocks have been so popular that the Vanguard Dividend Growth Fund shut its doors to new investors last month, with its managers citing a desire to "control asset growth" after attracting $3 billion in six months.
Investors are buying companies that pay a dividend even if they rate poorly on conventional measures of quality. And U.S. stocks have generally been on an upswing since February, a tide that has been lifting all boats, by and large.
DFND's bets against Newmont Mining Corp (NYSE:NEM), Freeport-McMoRan Inc and Exelon Corp (NYSE:EXC) have soured as the stocks rose instead.
Exelon, for instance, has spent more cash over the past year on core investments than it generated from business operations - even before paying dividends. But the electric utility saw its stock pop in February after promising to keep hiking dividends.
While DFND's average dividend-paying "long" stock is up 6.5 percent this year, its average "short" gained a punishing 44 percent, according to research service Morningstar Inc.
RIVAL FUND SIDESTEPS HAZARDS
DFND's only "long-short" dividend ETF competitor, QuantShares Hedged Dividend Income Fund, has managed to avoid similar hazards by shorting companies with low or inconsistent dividends.
The funds' differing approaches to determining what is a good short make for very different holdings. While DFND is long Citigroup (NYSE:C), suggesting it predicts the bank could raise its dividend, DIVA is shorting the bank because the current dividend is relatively small.
DIVA also spreads bets across more stocks, smoothing out overall performance. The fund shorts about 200 companies, while DFND bets against nine. DIVA's average long position is up 18 percent, while its average short is up 14 percent, Morningstar data shows.
Among DIVA's top bets are that Nordstrom Inc (NYSE:JWN), Targa Resources Corp and Macy's Inc could rise, while SBA Communications Corp (NASDAQ:SBAC), WPX Energy Inc and Zayo Group Holdings Inc could fall.
DFND is about $2.9 million in size, while DIVA invests $3.9 million in assets. Both ETFs have expense ratios slightly below 1 percent, which is above average in part because shorting stocks is typically more expensive than going long.
Helping both funds is the fact that they buy larger positions in their long holdings than their shorts.
Overall, DFND is down 3 percent since January, with its rival up 18.4 percent over the same period, according to Thomson Reuters Lipper. The S&P 500 has climbed around 8.5 percent this year, including dividends.
Reality Shares's Ervin is not backing down, warning investors that buying companies for their dividends without attention to their quality cannot work forever. In addition to holding on to the underperforming shorts, the ETF is betting on a rise in dividend-paying Tyson Foods Inc (NYSE:TSN), Waste Management Inc (NYSE:WM) and Linear Technology Corp (NASDAQ:LLTC).