SPHD ETF: Dividends And Defensive Sectors To Navigate Uncertainty (NYSEARCA:SPHD)

It has been volatile for the first week of the new year with the S&P 500 index ending slightly below 4700 or with losses of 0.96% as shown in the chart below which shows a snapshot of the price action from December 29 to January 5. On the other hand, the Invesco S&P 500 High Dividend Low Volatility ETF (NYSEARCA:SPHD) pictured in orange came out with five-day gains of 1.02%.

Now, this is a dynamic market and things may evolve differently as economic data are released, but, my objective with this thesis is to show that Invesco’s outperformance can continue. For this purpose, I will focus mainly on its sector composition and performance in the last two years which have been marked by the Federal Reserve aggressively tightening monetary policy, subsequently pressing the pause button with 2024 expected to be the year of rate cuts. I will also assess whether it has delivered on the low volatility mandate by comparing total returns with an S&P 500 tracking ETF.

First, in an environment where uncertainty is back, it is important to highlight why as a dividend-paying ETF, it is rate sensitive, whereby, in addition to fundamentals, performance is also determined by the actions of the U.S. Central Bank.

Both Economic and Political Uncertainty

In this respect, last Friday was marked by the release of two leading indicators: the December non-farm payrolls and the ISM services manufacturing. While the payroll data were stronger than expected, the jobs component of the ISM was much softer than expected. Therefore, these indicators contradicted each other and to obtain a sense of the market reaction, the United States 10-year Bond Yield (US10Y) climbed above the 4% level on Jan 5 for the first time since mid-December as charted below. This shows a decline in the demand for treasuries which points to a higher possibility of interest rates not being cut in March as has been widely expected after the Fed’s December meeting.

Yields eventually fell to below 4% on January 8 but, the chances for a rate cut in March have now retreated to 60% from 75% earlier. Also, tighter monetary policy is not favorable to equities and other risk assets which explains the S&P 500’s losses in the introductory chart. However, the fact that dividend-paying SPHD which pays yields of 4.42% and competes with risk-free treasuries gained despite facing higher treasury yields (of above 4% in the first week of January) suggests something else at play here like uncertainty as I further elaborate upon below.

Firstly, real GDP growth which is estimated to be 2.4% in 2023 is expected to slow down to 1.4% this year. At the same time, consumer spending which has helped to counter the effects of higher inflation and elevated interest rates has up to now received some support from job creation but the economy has been adding fewer jobs, down from a monthly average of 400K in 2022 to 225K last year. Thus, U.S. consumers may have been grinding on their savings and could decide to rebuild them, acting as a deterrent to spending, without forgetting that they face high borrowing costs too.

Therefore going forward it looks like a more cautious environment not only for households but also businesses, in terms of hiring as well as inventories. On top, there will be an election, one which will likely focalize both people’s and investors’ attention in the second half of this year, but even now some of America’s partners and allies are alarmed by the prospect of former President Donald Trump making a comeback as this could put into question policy decisions on some key economic engagements.

Reasons for SPHD’s Recent Outperformance and Assessing Whether it Can Continue

Now, one of the places to hide during times of uncertainty is in defensive sectors like utilities, which make up about 17.46% of SPHD as shown in the pie chart below. Real estate also constitutes a sizeable above 17.11% chunk.

To understand SPHD’s outperformance, I plotted the individual charts of the sectors of the S&P 500. Thus, the utilities sector has gained 1.75% in the last five days, as shown in the chart below. This is despite the US10Y going above the 4% range during the same period. Normally these two move in opposite directions due to utilities being rate sensitive, but the fact that it has not possibly shows that this sector is now assuming its role as a defensive sector for the uncertainty reasons mentioned earlier. For investors, a defensive sector is comprised of stocks that tend to exhibit relatively stable performance when the broader market becomes volatile and these typically include healthcare, consumer staples, and utilities.

On the other hand, real estate has lost 3% while consumer staples displayed gains of 0.2%, while healthcare was the top gainer with 2.10% while materials lost 1.81%.

Focusing on real estate which has played a major role in the ETF’s performance, it has lost 23% during the last two years (chart below) on the back of soaring mortgage rates. Some forecasts made earlier in 2023 point to a recovery in 2024 and this thesis could get some support from the 30-year fixed mortgage rate sliding from 7.8% in October to 6.62% on January 3. However, other factors are also at play like the supply of homes which remains limited thereby keeping their prices high.

Expanding the focus to commercial REITs, Simon Property Group (SPG) which is one of SPHD’s top holdings, has a growth grade of C- and its annual revenues are still lower than before the pandemic but its shares have already gained more than 40% since the end of October mostly due to rate cut bets but the latest data show that this could be delayed possibly to June. Therefore, one can expect volatility in the real estate sector, but this does not mean that you should sell.

SPHD has delivered on the Volatility Criteria when Compared to SPY and Considering Total Returns

The reason is that with more than 80% of non-real estate sector exposure, the ETF can deliver an upside in case defensive sectors come to the fore as the level of uncertainty rises further. For this purpose, based on its momentum grade of C+, whereby the price is above the 50-day, 100-day, and 200-day moving averages, it could surprise to the upside. Another factor that could also support such an upward trajectory is investors putting more money in a broader range of stocks instead of the Magnificent 7 since last year. Such a trend has already emerged according to Morningstar whereby higher returns are now being derived from relatively undervalued stocks which were left behind.

To this end, there has been a resurgence in Nvidia’s (NASDAQ:NVDA) shares and other semiconductor names on Monday, January 8 following news that it will be soon producing AI chips for the Chinese market. This provided support to the S&P 500 index which gained 1.36% as it dedicates 28.12% of its overall weight to IT. However, this enthusiasm for tech has not dampened the appetite for utilities, healthcare, and consumer staples since SPHD delivered gains of 1.05%. This market action supports Morningstar’s perspective concerning an underlying interest in more value names despite continued investment in tech.

Pursuing further, SPHD’s low volatility feature seems to have worked, at least for the past two years, a period of turbulence created by the Fed addressing the inflation problem using rates. As per the chart below, the ETF has delivered losses of 4.63%, but much better total returns of 3.17% for shareholders who have been reinvesting their distributions instead of cashing them out, meaning that even after subtracting the fees of 0.3%, one is still in the green.

Looking deeper, one of the reasons for producing such returns is the ETF managed to grow dividends during the last two years. Additionally, it holds 50 stocks from eleven different sectors, tracks the S&P 500 Low Volatility High Dividend Index, and restricts the weight of the individual holdings to 3.5% to reduce concentration risks.

Its low volatility feature is further justified compared with the SPDR S&P 500 ETF Trust ETF (SPY) for the last two years. Thus, while SPHD underperforms purely on a price basis, it outperforms SPY by 1.26% (3.77 – 2.51) when considering total returns as shown in the chart below.

SPHD Deserves Better Despite Risks

Thus, the Invesco ETF deserves better and based on its price-to-earnings of 12.32x, which is trading at a discount of 37% relative to SPY’s 19.67x, I have a target of $49.4 (43.3 x 1.14) for 2024. This is obtained by applying a 14% multiple on the current share price of $43.3 with such an upside possibly driven by the utilities sector which is still down by 9% during the last two years, together with consumer staples which is down by around 5%.

However, SPHD’s 17% exposure to the real estate sector as discussed earlier together with 11.4% of its weight dedicated to energy could pave the way for further downside risks. In this case, despite heightened geopolitical tensions in the Middle East as of the first of October, and subsequent disruption in shipping in the Red Sea, Brent oil futures are down by more than 20% since then. This is why a 14% upside appears more reasonable than 37%. To this end, healthcare’s contribution to the upside could be more limited as it has already recouped nearly all its two-year losses.

Finally, a comparison with other value, quality dividends, and low volatility ETFs which bear fees in the 0.2% to 0.3% bracket shows that SPHD does not necessarily charge less but, on the other hand, it pays the best yields and boasts the highest assets under management.