DHS ETF: 3.82% Yield After December Reconstitution, Still A Buy (NYSEARCA:DHS)

Investment Thesis

The Index tracking the WisdomTree U.S. High Dividend Fund (NYSEARCA:DHS) reconstituted on December 14, 2022, resulting in some significant changes shareholders should consider. The positives include a higher estimated dividend yield of approximately 3.80%, a cheaper valuation, improved diversification, and a better earnings growth rate. However, the changes resulted in a lower-quality portfolio, increased volatility, and less earnings momentum. This article summarizes the reconstitution and compares DHS’s new fundamentals with the two high-yield dividend ETF alternatives. I believe the positives outweigh the negatives, so I’ve maintained my buy rating and look forward to explaining why in further detail below.

DHS Overview

Strategy and Key Exposures

DHS tracks the WisdomTree U.S. High Dividend Index, selecting the top 30% of U.S. publicly-traded companies by their indicated dividend yields. Quality is determined by assessing each company’s return on equity, gross profits over assets, and historical risk-adjusted returns. The Index removes the bottom 10% of these companies and the top 5% of companies by dividend yield if they score in the bottom 50% on quality.

I doubt this extreme dividend yield screen is adequate. With this latest annual reconstitution, the Index still selected eight companies with double-digit yields (UWMC, OMF, BGFV, CWH, SVC, UNIT, HPP, STR). However, their combined weight is just 0.30%. The reason is that DHS is dividend-dollar-weighted, meaning a company’s weighting is determined by the product of its dividend yield and the number of shares outstanding. As a result, the Index favors larger companies with more free cash flow available to distribute.

WisdomTree updates its holdings daily, and the top ten are listed below. Exxon Mobil (XOM), Pfizer (PFE), Chevron (CVX), and AbbVie (ABBV) are about 5% each. Except for Pioneer Natural Resources (PXD), all yield above 3%. However, PXD has paid additional special dividends for five consecutive quarters. The company’s 2022 dividend payments totaled $25.44/share, which is 11.22% of its current share price.

Financials and Energy make up about 19% of the portfolio, followed by Utilities (13.48%), Health Care (12.81%), and Consumer Staples (11.46%). This composition is significantly different than what the WisdomTree U.S. Dividend Growth ETF (DGRW) features. DGRW, whose Index also reconstituted this month, has nearly zero exposure to Energy and Utilities companies. The idea is for dividend investors to hold them both, but one disadvantage is a consistently higher expense ratio across WisdomTree’s U.S. domestic dividend ETFs. DHS and DGRW have 0.38% and 0.28% expense ratios, effectively reducing net distributions and counter to their investment objectives.

Performance and Dividends

There are many high-dividend ETFs on the market today. I track 25, plus several others that generate additional income through strategies like covered call writing. Sticking with the pure U.S. Equity ETF universe, DHS is one of 11 monthly payers, is the 11th largest by assets under management, and has the 15th highest expense ratio.

The following chart highlights DHS’s performance since its inception against the iShares Select Dividend ETF (DVY) and the SPDR S&P Dividend ETF (SDY). These peers have histories longer than DHS, so it’s nice to see how they each performed in numerous market uptrends and downturns.

DHS had the lowest annualized returns (7.14%) and the highest standard deviation (16.65%) over this extended period, and a massive 63.03% drawdown suffered from June 2007 to February 2009. Only SDY was competitive with SPY on drawdowns, suggesting that high-dividend ETFs don’t always offer the downside protection one might assume. These three ETFs also lost 6-10% more than SPY in Q1 2020, though they’ve more than made up for that in 2022.

More recently, DHS has underperformed peers like the Schwab U.S. Dividend Equity ETF (SCHD), the Vanguard High Dividend Yield ETF (VYM), and the Invesco High Yield Equity Dividend Achievers ETF (PEY). Since SCHD’s inception in October 2011, DHS has lagged by 1-3% per year. Risk-adjusted returns (Sharpe and Sortino Ratios) were also the lowest.

From a dividends perspective, dividend growth is potentially an issue. Despite a higher starting yield beginning in 2012, DHS fell behind VYM in yield on cost ten years later. DHS’s ten-year annualized dividend growth rate is just 2.85% compared to 12.20% and 7.40% for SCHD and VYM.

This poor dividend growth rate contributes to a mediocre “C” Seeking Alpha Dividend Grade. Its 3.41% trailing dividend yield is the bright spot, but SCHD is competitive at 3.38%.

DHS Reconstitution Recap

The following reconstitution summary of the Index’s top ten holdings was provided by WisdomTree, highlighting how one of the significant changes was a simple re-weighting of Energy stocks like Exxon Mobil (XOM). On December 14, 2022, XOM’s weighting declined by 3.51%, a change you could describe as taking profits on a 73% YTD gain. This move appears prudent, even if it’s only following a set of rules.

AT&T (T), International Business Machines (IBM), and Pioneer Natural Resources (PXD) were the key additions with weights between 2-3%. Meanwhile, Coca-Cola (KO), Merck & Co. (MRK), and Verizon Communications (VZ) were deleted, with previous weights between 3-5%. Overall, the reconstitution was substantial. Apart from regular re-weighting of current constituents, the Index added 155 (21.58%) holdings but removed just 70 (30.16%). Therefore, there are 85 more than before, making DHS a more diversified ETF.

WisdomTree provides factor summaries on quality, value, and momentum. Like with DGRW, the percentage of “good” momentum stocks fell substantially (68.8% to 51.2%). However, value improved, and quality stayed the same. My fundamental analysis mostly confirms this, but profitability scores suggest a decrease in quality, which I’ll discuss shortly.

The improvement in value is expected for any high-dividend ETF at reconstitution time since high-dividend stocks, which have lower prices, are favored. Investors should also expect a certain degree of style drift between reconstitutions. Those wanting a consistently “cheaply-valued” portfolio should opt for high-dividend ETFs that frequently reconstitute, like HDV. DHS only reconstitutes annually, so if earning high dividends is the primary objective, buying around this time is most beneficial.

With the addition of PXD, DHS’s Energy exposure is still high. However, the most significant change was a 6% increase in Financials and a corresponding decline in Consumer Staples exposure. As a result, the portfolio is more volatile than before. One year from now, the probability of a recession is 38.06%, according to a model that uses Treasury yield spreads as its inputs. In such a scenario, these sector exposure changes will likely be detrimental.

DHS Analysis

The following table highlights DHS’s fundamental metrics for its top 25 holdings. I’ve included summary metrics for the ETF, pre- and post-reconstitution, SCHD, and PEY. PEY veers a bit more toward the low end of the large-cap universe, and although its 0.52% expense ratio is a huge negative, the yield is competitive.

The Negatives

The first negative is the added volatility, indicated by the increase in beta from 0.87 to 0.95. PXD is one reason, but DHS added 3.82% to Regional Bank stocks like Truist Financial (TFC) and PNC Financial Services (PNC). DHS now has more exposure to this sector than SCHD (8.05% vs. 6.10%), and these stocks often perform poorly in drawdowns. Here are the performance statistics since October 2011 for KBWR, KRE, and IAT, three Regional Bank ETFs following a tiered, equal, and market-cap-weighting scheme. The maximum drawdown figures are about 20% worse than the SPDR S&P 500 ETF (SPY).

Second, if profitability is considered a proxy for quality, DHS became less attractive post-reconstitution. Again, adding lower-priced stocks is expected with high-dividend ETFs, but the decline in the fund’s profitability score (8.95/10 to 8.51/10) suggests that lower prices are warranted. Also, consider the stocks the Index dropped this December. Here are the top six by weight. All have “A+” Seeking Alpha Profitability Grades and above-average EPS Revision Grades. In short, DHS has eliminated some strong recent performers that did well for a reason, which is not an approach I favor.

The Positives

While higher volatility, weaker profitability, and declining earnings momentum are key negatives, this month’s reconstitution resulted in some noteworthy positives. They include a higher estimated dividend yield, cheaper valuation, improved diversification, and stronger earnings growth potential. To bring these metrics back into focus, here they are again for DHS’s top 25 industries.

DHS’s gross dividend yield is 4.20% or 3.82% after fees. That’s 0.27% better than before and 0.31% more than SCHD. PEY offers a 4.75% gross dividend yield (4.23% net), but its 6.99/10 profitability score and lower earnings growth rates are red flags and may be more appropriate for speculative rather than conservative investors. Plus, although DHS’s yield is now 0.41% less than PEY’s, its constituents have a better five-year dividend growth record.

The above table also highlights DHS’s improved diversification, measured by concentration in the top 25 industries (87.81% vs. 92.54%). It’s a better “all-in-one” high-dividend ETF if that’s what you seek. Before, Integrated Oil & Gas stocks comprised 15.17% of the portfolio, or about 5% more. Finally, DHS trades at just 12.65x forward earnings and has an estimated 10.68% earnings growth rate. Both metrics moved in the right direction and now look better than SCHD, a benchmark for many dividend investors.

Investment Recommendation

DHS’s reconstitution was eventful and resulted in critical changes to the portfolio’s fundamentals. I dislike how the Index removed high-quality stocks like Coca-Cola and Merck & Co and replaced them with more speculative Regional Bank stocks. These changes reduced the portfolio’s profitability score and increased its volatility, which may prove problematic in a recession.

Still, the expected net dividend yield of 3.82% will undoubtedly be attractive to DHS’s target audience. The added growth from those Regional Bank stocks may prove beneficial if the Federal Reserve can achieve its “soft landing goal” in 2023. And finally, improved diversification and a cheaper valuation doesn’t hurt. Overall, the positives outweigh the negatives, so I’ve decided to maintain my buy rating. Thank you for reading, and I look forward to discussing DHS and other high-dividend alternatives in the comments section below.