Fund Spotlight

Fixed income investors who rely on interest rate-based returns for income have been hit especially hard over the past 8 years due to quantitative easing policies. Under most economic circumstances, the yield curve slopes toward increased rates in proportion to increased duration. Prices and yields move inversely due to demand. The result of the normal yield curve shows that longer-term interest rates are more sensitive to market changes, thus pricing volatility is significantly more pronounced in 10- to 30-year bonds versus 30-day bonds.

Interest rates and bank stocks have surged in the wake of the U.S. election as market sentiment drastically improved alongside confidence in U.S. growth prospects. Long-term rates have increased as much as 40 basis points on the 10-year Treasury bond over the past month, leading to an even larger swing on the 30-year Treasury. Rising rates on shorter-term bonds, however, have been impacted less, with 1-year Treasuries moving roughly 15 basis points over the same period.

Short-term bond funds tend to perform better during periods of bond sell-offs and rising interest rates due to reduced volatility on near-term fixed income products relative to longer maturities. Due to attrition that would normally correspond with a limited maturity, turnover on shorter-term bonds would understandably be greater than on longer-term holdings, affording a shorter-term portfolio the ability to mitigate the impact of rate change cycles more quickly. Morningstar total cumulative return statistics have shown that short-term bond funds have been the only major investment fund product category to post positive total returns during the last three rate hike cycles of 1994 to 1995 (13 month +275 basis points), 1999 to 2000 (12 month +150 basis points), and 2004 to 2006 (25 month +400 basis points).

The Fidelity Short Term Bond Fund (FSHBX) is worth considering for investors seeking to hedge a portion of their portfolio.

Strategy

The Fidelity Short Term Bond Fund (FSHBX) has a Silver 3-star Morningstar rating and a relatively low 2-star risk rating. It has been consistently delivering relatively high income while preserving capital since 1986. A minimum of 80 percent of the $6.55 billion fund is invested in both domestic and international investment-grade bonds or repo agreements. To boost returns while offsetting risk, FSHBX targets its largest portfolio allocation toward AAA-rated U.S. Treasuries but is underweight relative to the Barclays U.S. 1-3 Year Government/Credit Bond Index (20 percent vs. 58 percent), while overweight higher-yielding corporates (49 percent vs. 27 percent). FSHBX’s stated policy goal is to maintain a dollar-weighted average duration of not more than 3 years.

However, while 68 percent of the portfolio is in maturities of 1 to 3 years, the goal of maximizing income while protecting capital has tilted toward some slightly longer maturities. 19.86 percent of bonds in the portfolio are 3 to 5 years, 1.84 percent are 5 to 7 years, 0.53 percent are 7 to 10 years, 1.52 percent are 10 to 15 years, 1.37 percent are 15 to 20 years, 2.71 percent are 20 to 30 years, and 4 percent are over 30 years.

Holdings

Per the fund’s strategy, FSHBX’s top 5 holdings are an assortment of U.S. Treasury notes, ranging in yield from 0.75 to 1.375 percent, accounting for 16.2 percent of the portfolio. Domestic issues make up 83.50 percent of bond holdings, with international bonds from the United Kingdom, Japan and Canada being the primary non-U.S. positions. The overall composition of the portfolio is approximately 20.3 percent U.S. Treasuries, 49.3 percent corporates, 27 percent mix of mortgage-backed and asset-backed securities, and 2.7 percent in cash. Within the corporate arena, preferred sectors include tobacco, auto, financial and banking. Notably, Ford Motor Company and Citigroup account for 1.49 and 2.05 percent of the portfolio, respectively.

Performance

With a turnover rate of over 130 percent, FSHBX has a year-to-date return of 1.85 percent and a 0.96 percent yield. From a growth perspective, a $10,000 investment would be worth $11,843 over the course of 10 years. Trailing total returns for 1 year were 1.09 percent, 0.91 percent for 3 years, 1.19 percent for 5 years, 1.64 percent for 10 years, and 2.34 percent for 15 years. Given the objective of the fund, these returns are quite respectable.

As befits its intended inoculation to market volatility, FSHBX’s past 12-month high-to-low price fluctuation has stayed +/- a total of 11 cents.

Management

Rob Galusza has run FSHBX since 2007, with Robin Foley joining him in 2008. Fostering a conservative approach, their numerical returns lag somewhat at face value, but exceed their peers’ when factoring in a risk adjustment basis. This philosophy protected FSHBX well in 2013 when Fed Chairman Bernanke spooked the market with comments that drove most rival bond funds down 0.64 percent, while FSHBX fell only 0.03 percent. Though neither had ever run a mutual fund before, Galusza and Foley had a 20-year history of collaboration at Fidelity before undertaking FSHBX.

Investment Minimums & Fees

The investment minimum is $2,500. FSHBX’s expense ratio is a low 0.45 percent versus the category average of 0.80 percent. There are no transaction fees, redemption fees or loads. Management actual fees are 0.31 percent, and management maximum fees are 0.20 percent.

Recommendation

The recent spike in interest rates was once again a reminder of why short-term bonds are useful in a portfolio. FSHBX fell 0.38 percent in November, while Fidelity Intermediate Bond (FTHRX) fell 1.83 percent and Fidelity Long-Term Treasury Bond Index (FLBIX) plunged 7.85 percent. If bond yields do not stop rising in 2017, the gap between these numbers will only grow larger. Investors should check the duration of their bond funds and be sure they are comfortable with the level of risk in their fixed income investments. Currently we have issued a Strong Buy recommendation with a ranking of 86.

After pulling back in late 2015 and early 2016, the Nikkei 225 has resumed the bullish rise that began four years ago in response to what has been called “Abenomics.” Named in honor of Japanese Prime Minister Shinz? Abe, the economic policies that he advocates are based on “three arrows” of structural reform, fiscal stimulus and monetary easing aimed at spurring the Japanese economy, boosting gross domestic product (GDP) and increasing the nation’s exports.

Nearly all of the world’s central banks have engaged in some form of extraordinary monetary policy since the global financial crisis, although the measures instituted by the Bank of Japan (BoJ) have been the most aggressive by far. While the BoJ has signaled that it will begin to tighten monetary policy and taper its bond purchases, the central bank will continue to expand the country’s monetary base until inflation reaches the 2 percent target by pinning the yield on the benchmark 10-year government bond at zero percent.

The postelection U.S. dollar rally has significantly weakened the yen. Prudent investors expect the yen’s infirmity to persist in light of Japan’s overwhelming government debt and the deflationary effects of a stronger U.S. dollar. WisdomTree’s Japan Hedged Equity Fund (DXJ) is well-positioned for such climates and should be considered by those who are bullish on Japanese stocks and bearish on the yen.

Fund Overview

This exchange-traded fund (ETF) seeks to track the returns of WisdomTree’s Japan Hedged Equity Index. Generally, 95 percent of the passively managed fund’s $7.1 billion in assets under management (AUM) will be invested in components of the index or other investments that have substantially identical economic characteristics. The index is designed to neutralize fluctuations between the yen and the dollar while providing exposure to Japanese equity markets.

Investment Strategy

DXJ is slanted toward dividend-paying companies incorporated in Japan that have an export tilt and are listed on the Tokyo Stock Exchange. The companies need to derive less than 80 percent of their revenues from inside Japan. Thus, holdings typically have greater exposure to fluctuations in world currencies and may decline when the yen appreciates. Selection criteria include paying at least $5 million in annual cash dividends, a market capitalization of at least $100 million and an average daily trading volume of $100,000. The index is dividend-weighted and rebalanced annually. While the maximum exposure to a single company is capped at 5 percent, a sector weighting cannot exceed 25 percent. The ETF enters into forward currency and futures contracts designed to offset the portfolio’s total exposure to the yen.

Portfolio Composition and Holdings

With an average market cap of $18 billion, which is slightly lower than the underlying index, the portfolio has a 59.16 percent exposure to giant-cap shares and a 25.86 and 12.11 percent exposure to large- and mid-cap stocks, respectively. The ETF also has a 2.8 percent investment in small-caps and negligible exposure to micro-cap shares. In addition to a P/E ratio of 13.16, the ETF has a price-to-book ratio of 0.92. The fund is overweight basic materials, consumer cyclical and financial services sectors while underweight communication services, consumer defensive and technology shares. The top 10 holdings account for approximately 32 percent of AUM. In descending order, they are Toyota, Mitsubishi UFJ Financial, Sumitomo, Mizuho Financial and Japan Tobacco, followed by Canon, Nissan, Honda, Takeda Pharmaceutical and Mitsui.

Historical Performance, Risk and Fees

Featuring a Morningstar average return rating, DXJ has delivered total one-, three- and five-year returns of -8.06, 4.79 and 13.35 percent, respectively. These compare with the Japanese stock category averages of -3.28, 4.69 and 9.87 percent, respectively, over the same periods. The ETF has a three-year beta of 0.94 and a standard deviation of 19.27. The category averages are 0.76 and 14.04, respectively. DXJ has an expense ratio of 0.48 percent.

DXJ is suitable for investors with a well-balanced core portfolio who are looking for additional hedged exposure to Japanese equities. This popular ETF is positioned to benefit from the increased economic activity in Japan spurred on by Abenomics and the weakening of the yen versus the U.S. dollar. DXJ is one of the most liquid funds in the segment. An alternative investment for investors is the iShares Currency Hedged MSCI Japan Fund (HEWJ). This ETF invests in iShares MSCI Japan (EWJ) and adds a currency hedge. For investors who still want a passive index approach, this fund has sufficient volume and charges the same fees as DXJ. We prefer DXJ because it focuses on dividend payers and tilts the portfolio in favor of exporters who will benefit from a weaker yen.

We have raised our recommendation for DXJ to a Strong Buy with a ranking of 87.

Choosing mutual funds that outperform the market can be difficult, leading many investors to opt for low-cost passive funds. While passive investing garners considerable attention, active investing offers unique benefits that should not be overlooked. Vanguard’s long-term accomplishments demonstrate the advantages of hedging, risk management and flexibility utilized in active management. Talented fund managers with strong track records generally outperform, particularly in less publicized market segments, such as small-caps or international markets.

Low management fees that are competitive with passive investments are possible when active managers apply a disciplined approach. Investors should, however, allow for a longer horizon since they are investing in a manager and a strategy that may see periods of underperformance. The compound returns generated during the up years can offset losses incurred during years of poor performance. This philosophy has enabled Vanguard to attract significant capital inflows into actively managed funds over the past year.

Vanguard’s Growth and Income Fund (VQNPX) is a strong offering with historically modest returns that has consistently outperformed its S&P 500 Index benchmark. The fund has also demonstrated lower downside risk than that of its category peers.

Investment Strategy

VQNPX breaks the portfolio into several sleeves to attain a broadly diversified portfolio of stocks with investment characteristics similar to those contained in the S&P 500, but designed to outperform it. The current managers have been in place since September 2011. Managers and sub-managers work within tight constraints to keep the tracking error low and the beta in line with the index.

When selecting an investment, sub-adviser Los Angeles Capital emphasizes market-cap size, growth and the stock’s beta. The firm also determines whether the market is placing a premium on the prospective company’s shares. The team is led by managers Thomas Stevens and Hal Reynolds.

With Anne Dinning at the helm, a team of eight analysts at sub-adviser D.E. Shaw utilizes models designed to find price inefficiencies. They seek to offset traditional quantitative factors likesuch as value, size and momentum in their analysis by employing other investment criteria, such as trading volume and price movement. They also consider such factors likeas acquisitions and the strength of the company’s balance sheet.

Vanguard’s in-house quantitative equity group manages the third sleeve. Their goal is to create a high-quality portfolio characterized by moderate valuations, positive momentum and strong earnings growth. Two of the three sub-advisers match the S&P 500’s sector weightings, while sub-adviser Los Angeles Capital sometimes deviates.

Portfolio Composition and Holdings

VQNPX falls into the large– blend category because it must invest at least 65 percent of assets under management (AUM) in stocks contained within the S&P 500. Typically, the percentage of AUM invested in the index exceeds 90 percent. At the end of September 2016, the fund was almost entirely invested in domestic stocks and held 1,074 individual investments, more than double the benchmark.

The portfolio has 42.6 percent of AUM invested in giant-cap shares as well as a 33.3– and 21.95–  percent exposure to large- and mid-cap shares, respectively. Along with a marginal exposure to micro-cap shares, less than 2 percent is allocated to small-caps. The fund’s 10 largest holdings represent 15.9 percent of AUM. In descending order, top holdings are Apple, Johnson & Johnson, Microsoft, Exxon Mobile and Amazon. These are followed by Alphabet, General Electric, AT&T, Proctoer & Gamble and Citigroup.

The management team’s doctrinal approach has produced a portfolio with a valuation that is slightly lower than the benchmark. At 20.4 times earnings, the portfolio has a P/E ratio below the S&P 500’s 22.2. The 2.8 price-to-book ratio is also slightly lower than the benchmark. The average market cap of VQNPX is $44.6 billion, which is approximately half of the S&P’s average. VNQPX is overweight energy, industrials, health care and consumer defensive sectors, and underweight financial services, real estate and technology. Although there is some deviation from the index, sector weightings are usually within 2 percent of those found in the benchmark index.

Historical Performance and Risk

The fund has consistently delivered on the managers’ goal of inching ahead of the benchmark index. Since September 2011, the current management team beat the S&P 500 by an annualized 44 basis points. Although it is not a passive fund designed to completely mimic the benchmark, the fund’s tracking error is less than 1 percent over the past five years.

With a four-star Morningstar rating, VQNPX has delivered average annual one-, three- and five-year returns of 3.93, 9.08 and 13.97 percent, respectively. These compare towith the S&P 500 returns of 4.51, 8.84 and 13.57 percent, respectively. The fund has a high return and a below– average risk rating from Morningstar.

VQNPX has a three-year beta of 0.98 compared towith the large-blend category beta of 1.00. The fund’s three-year standard deviation of 10.5 is lower than the category average of 11.07.

Fees, Expenses and Distributions

No-load VQNPX is one of the least expensive actively managed funds in the large-blend category. The fund’s 0.34 percent expense ratio is competitive with its passively managed peers despite its high annual turnover costs and performance fees paid to D.E. Shaw and Los Angeles Capital, a testament to Vanguard’s acumen in keeping costs low.

The fund distributes long- and short-term capital gains annually in December. Semiannual income distributions occur in June and December. The most recent income distribution occurred June 2016 for $0.402 per share with a reinvestment price of $40.17. The fund is scheduled to pay a capital gain of 4.63 percent on December 22, 2016. Investors in taxable accounts may want to wait until after this gain is paid before buying.

There is a $3,000 minimum initial investment.

Suitability

VQNPX provides a diversified low-cost portfolio in a single fund that may be an appropriate core holding. VQNPX may weather a period of rising interest rates better than a typical bond fund as it generates current income and potential capital appreciation and holds stocks that regularly increase dividends.  Currently, we rank the fund as a Strong Buy with a Ranking of 88.

The Fidelity New Millennium Fund (FMILX) seeks capital appreciation by investing in both domestic and foreign common stocks. Fund managers look for holdings that stand to benefit from long-term trends and changes in the marketplace, such as product innovation, advances in technology and new governmental policies. Managers also consider adjustments in the economy, demographics and social attitudes. The fund invests in value and growth stocks across the full spectrum of market capitalization.

Investment Strategy

A member of the Fidelity team since 1999, John Roth is an experienced manager who took the helm of FMILX in July 2006. Supported by a staff of 135 analysts, Roth has successfully implemented a growth-oriented, valuation-sensitive investment strategy that has performed well over time. Although there is some overlap with Fidelity’s Mid-Cap Stock Fund that Roth also oversees, the fund’s performance is measured against a benchmark of the Standard & Poor’s 500 index (S&P 500). FMILX has moved from mid-growth to the large-growth category in recent years. While FMILX skews toward large-cap names, Roth still uses an all-cap approach for stock selection that expands beyond the confines of the benchmark. The fund’s overall market cap weighting is typically well below that of the category average and its S&P 500 benchmark. His primary focus is on areas of the economy that he believes are poised for secular change.

On the growth side, Roth looks for companies with highly regarded products and services that also demonstrate strong earnings potential. Investment criteria include companies with attractive valuations that are out of favor and have a catalyst for improvement. The management team holds a number of modestly sized investments to mitigate company-specific risk and generate attractive risk-adjusted returns over time. Roth casts a wide net across sectors, market caps and geographic regions when evaluating opportunities. Roth also breaks from his peers by incorporating out-of-favor cyclical stocks using a process that most growth managers avoid. The fund’s value-sensitive approach can result in it being out of step with its pure growth-oriented peers. Roth is a bit of a contrarian and tilts the fund toward value stocks based on the current stage of the recent bull market.

An early entry into energy shares was detrimental to the fund in 2015, but has paid off in 2016. Roth has also diverged from the benchmark with his overweighting of financial names. The strategy has produced strong returns during his tenure as fund manager. The team also considers economically sensitive cyclical names based on supply-and-demand dynamics within the firm’s industry and the current business cycle’s earnings potential.

Portfolio Composition and Holdings

As of September 2016, the three-star Morningstar-rated large-growth fund had $3 billion in assets under management. There are 165 individual stocks in the portfolio. The fund has an 86 percent exposure to domestic shares and 10.69 percent invested in foreign issues. The majority of the foreign investment is in developed markets, primarily Canada, France and the United Kingdom. The fund holds slightly more than 3 percent in cash. In addition to a 21.98 percent exposure to giant-cap shares, FMILX has 32.78 percent in large-caps and 33.17 percent invested in mid-caps, with 8.11 percent allocated to small-caps and 3.97 percent to small- and micro-cap shares. FMILX is underweight health care, consumer cyclical and discretionary sectors and is overweight energy, financial services and information technology. The top 10 holdings comprise 10.32 percent of AUM and include (in descending order) Cisco, Facebook, Williams Companies, Verizon, Chevron, Amgen, Eurofins Scientific, Visa, Boston Scientific and Bank of America. The portfolio has a P/E ratio of 20.09 and a price-to-book ratio of 2.12. FMILX has a 57 percent turnover ratio that is several percentage points below the category average.

Historical Performance and Risk

The fund benefited recently from underweighting biotechnology, life sciences and pharmaceuticals based on concerns about drug prices and possible political investigations into various industry practices. The fund’s overweighting of the energy sector was also beneficial, as commodity prices rebounded. An allocation toward financial services as bank stocks have risen in anticipation of higher rates has also pushed FMILX ahead of many competitors.

FMILX has delivered one-, three- and five-year returns of 14.57 percent, 7.87 percent and 14.7 percent, respectively. These compare with the category averages of 10.6 percent, 9.23 percent and 14.98 percent over the same periods. FMILX has delivered an overall return of 13.14 percent since its inception in 1992. With a three-year beta and standard deviation of 0.98 and 11.53, the fund earns a below-average risk rating from Morningstar.

Fees, Expenses and Distributions

FMILX has an initial minimum investment of $2,500 with no subsequent minimums. There is a $2,000 minimum balance requirement. The 0.71 percent management fee for FMILX is below the average for its peers. An additional performance fee can change the expense ratio. Because the fee is based on the fund’s three-year performance relative to the S&P 500, investors do not pay the fee when managers underperform. The highest fee during Roth’s tenure was 1.09 percent. Roth has over $1 million of his own money invested in the funds that he manages, which aligns his interests with those of shareholders. The fund made long-term capital gains distributions in December 2015 and January 2016 for $3.668 and $0.152 per share, respectively. There was also a dividend income distribution of $0.345 per share in December 2015.

Outlook

The fund’s above-average investments in small- and mid-cap shares as well as its exposure to cyclical stocks can increase volatility. The advantage is that the fund has captured 109 percent of the gains of its underlying benchmark. Roth’s stock-picking acumen has paid off in numerous sectors, especially financials, energy and consumer staples. Thus, the fund is a good long-term vehicle for investors seeking capital appreciation. Currently, we have ranked this fund as a Strong Buy with a Ranking of 85.

Fidelity launched six new ETFs in September, including Fidelity Core Dividend (FDVV), a new entrant in the highly competitive dividend ETF field.

The Core Dividend ETF is based on the Fidelity Core Dividend Index, which is “designed to reflect the performance of stocks of large- and mid-capitalization dividend-paying companies that are expected to continue to pay and grow their dividends.” It uses three factors to select stocks for the fund. The most important is trailing 12-month dividend yield, accounting for 70 percent. The payout ratio, or how much of earnings is paid out in dividends, is 15 percent. Dividend growth over the past 12 months is also 15 percent.

With yield by far the most important factor for selecting holdings, it’s no surprise that FDVV sports a portfolio yield approaching 4 percent (we still haven’t seen a 30-day SEC yield, but an examination of the portfolio less expenses gives an estimate in the high 3 percent range). This qualifies FDVV as a high-dividend yield fund, comparable to Vanguard High Dividend Yield (VYM) and iShares Core High Dividend (HDV), which yield 3.19 percent and 3.72 percent, respectively.

Portfolio Construction

After passing through those fundamental screens, holdings in FDVV are first weighted by market cap, then adjusted so that holdings are more equally weighted. The top holding was recently ONEOK (OKE), a $10.6 billion market cap gas utility at 3.0 percent of assets, followed by the $358.9 billion market cap Exxon Mobil (XOM) at 2.9 percent of assets. Although FDVV, HDV and VYM all have similar average market capitalizations, there are some differences. HDV is a mega-cap fund with the largest of large-caps and falls in the middle of Morningstar’s value box. VYM is a borderline mega-cap fund that leans toward Morningstar’s blend box.

FDVV is in the middle of Morningstar’s large-cap box, but it is a borderline deep value fund. It has 65 percent of assets in large-cap, 25 percent in mid-cap and 9 percent in small-cap.

Sector Exposure

FDVV holdings are also weighted by sector, with higher-yielding sectors given an overweight position in the fund. We can see the effects of this most clearly in the sub–industry exposure, with oil, gas and consumable fuels taking up 17 percent of FDVV’s assets. FDVV’s exposure within this sector is also unique because it includes a lot of Mmaster Llimited Ppartnerships (MLPs). These stocks tend to cluster in the energy industry, with pipeline and energy production companies dominating. Dividends are high because earnings are passed through to the unitholder, avoiding taxation at the corporate level. MLP dividends boost the overall yield of FDVV, but creates substantial energy exposure. Theis energy weighting in FDVV is like that of HDV, which has 19 percent in the sector (the largest sector in HDV), but HDV doesn’t make use of MLPs. VYM has much less energy exposure at 10.5 percent of assets.

As for the utilities and telecom sectors that dominate many dividend funds, FDVV is moderate in its exposure. Telecommunication services is 8 percent of assets, the sixth–largest sector in the fund, less than HDV’s 14 percent and more than VYM’s 6 percent. Utilities are nearly 10 percent of FDVV’s assets, versus 9 percent in HDV and 8 percent in VYM.

Consumer discretionary is the largest sector in FDVV at 18 percent of assets. Only 4 percent of HDV and 6 percent of VYM are in this sector, creating a huge difference with these funds. Sub–industries in this sector include hotels, restaurants and leisure (4 percent of assets), media (4 percent) and specialty retail (3 percent).

Financials are 16 percent of assets in FDVV, versus only 1 percent in HDV and 13 percent in VYM. Banks are the largest chunk of this at 6 percent of assets.

Technology exposure is solid for a dividend fund, but underweight versus HDV and VYM. FDVV has 12 percent of assets in tech, versus 15 percent in HDV and VYM.

FDVV is substantially and surprisingly underweight consumer staples. This sector tends to dominate dividend funds because it is a steady, reliable and growing source of dividends, but it is the smallest sector in FDVV at 2 percent of assets, compared towith 19 percent in HDV and 15 percent in VYM. It is the largest sector in VYM and almost the largest in HDV.

Finally, healthcare is underweight in FDVV at 6 percent of assets, more than half of which comes from pharmaceutical stocks. In HDV and VYM, healthcare accounts for 15 percent and 11 percent of assets, respectively.

FDVV top 10 holdings account for 25 percent of assets, less than the 32 percent in VYM and the 57 percent in HDV. Exxon (XOM), AT&T (T), Verizon (VZ) and Chevron (CVX) are top ten10 holdings in all three funds.

Income

FDVV is a high-income fund, one that will rely on the energy subsector to deliver growth. Investors who prefer high current income to dividend growth should consider the fund alongside existing ETF options such as HDV and VYM, and ahead of lower–yielding, but faster–growing options such as Vanguard Dividend Appreciation (VIG). In contrast, investors looking for income growth should hold off on FDVV until we see evidence of its dividend growth.

Risk

Investors also must weigh their risk tolerance and time horizon. The inclusion of MLPs adds another additional layer of potential volatility. MLP funds fell more than 50 percent as oil prices declined from 2014 to early 2016. Rising interest rates could present another headwind if there’s no offset from a rebound in energy prices.

Head-to-Head

FDVV is most similar to HDV in terms of yield and portfolio exposure. Investors aren’t taking on more energy risk by swapping from HDV to FDVV. They will substantially increase exposure to consumer discretionary and financials though.

FDVV is not as similar to VYM. While VYM is a high yield fund, it also has a very balanced portfolio because it doesn’t chase yield. Thus, VYM has a much lower yield than FDVV and HDV, but it should be more stable due to greater sector diversification. An investor moving from VYM to FDVV is adding energy and consumer discretionary, while reducing industrials, healthcare and consumer staples exposure.

FDVV is more compliementary of VYM, and will be best used as a replacement for existing high yield positions.

Conclusion

FDVV has less than one–month of history, and while the fund is solidly constructed, we would wait before adding more than a niche position in the fund. There’s no significant yield advantage versus HDV, a similar fund with a long track record. HDV also charges far less, at 0.08 percent in expenses, versus 0.29 percent for FDVV, and it has much greater liquidity. VYM only charges only 0.09 percent, and FDVV isn’t a good replacement for VYM unless the goal is solely higher yield.

Although we focused on VYM and HDV in this article, there are many other dividend funds available. iShares Select Dividend (DVY) has high utility exposure and consumer discretionary as its second–largest sector. Putting DVY head–to–head with FDVV, we like the greater diversification in FDVV, the lower expense ratio (DVY charges 0.39 percent) and what should be a slightly higher yield.

Investors must be mindful of existing portfolio exposure. Those already tapping MLPs or energy sector stocks for yield should consider whether FDVV would add too much exposure.

Finally, while current income is important, growth is key for any investor with a time horizon that stretches beyond a few years. DVY, for example, has a much higher yield than dividend growth ETFs, but its payout growth lagged over the past decade. The longer an investor’s time horizon and the lower the need for current income, the less appropriate is a fund such as DVY or FDVV. Growth–oriented funds such as VIG are the better option. If you have questions about whether any of these ETFs are the right investment choices for you, please call us at 888-252-5372. 

HDV), which yield 3.19 percent and 3.72 percent, respectively.

Portfolio Construction

After passing through those fundamental screens, holdings in FDVV are first weighted by market cap, then adjusted so that holdings are more equally weighted. The top holding was recently ONEOK (OKE), a $10.6 billion market cap gas utility at 3.0 percent of assets, followed by the $358.9 billion market cap Exxon Mobil (XOM) at 2.9 percent of assets. Although FDVV, HDV and VYM all have similar average market capitalizations, there are some differences. HDV is a mega-cap fund with the largest of large-caps and falls in the middle of Morningstar’s value box. VYM is a borderline mega-cap fund that leans toward Morningstar’s blend box.

FDVV is in the middle of Morningstar’s large-cap box, but it is a borderline deep value fund. It has 65 percent of assets in large-cap, 25 percent in mid-cap and 9 percent in small-cap.

Sector Exposure

FDVV holdings are also weighted by sector, with higher-yielding sectors given an overweight position in the fund. We can see the effects of this most clearly in the sub–industry exposure, with oil, gas and consumable fuels taking up 17 percent of FDVV’s assets. FDVV’s exposure within this sector is also unique because it includes a lot of Mmaster Llimited Ppartnerships (MLPs). These stocks tend to cluster in the energy industry, with pipeline and energy production companies dominating. Dividends are high because earnings are passed through to the unitholder, avoiding taxation at the corporate level. MLP dividends boost the overall yield of FDVV, but creates substantial energy exposure. Theis energy weighting in FDVV is like that of HDV, which has 19 percent in the sector (the largest sector in HDV), but HDV doesn’t make use of MLPs. VYM has much less energy exposure at 10.5 percent of assets.

As for the utilities and telecom sectors that dominate many dividend funds, FDVV is moderate in its exposure. Telecommunication services is 8 percent of assets, the sixth–largest sector in the fund, less than HDV’s 14 percent and more than VYM’s 6 percent. Utilities are nearly 10 percent of FDVV’s assets, versus 9 percent in HDV and 8 percent in VYM.

Consumer discretionary is the largest sector in FDVV at 18 percent of assets. Only 4 percent of HDV and 6 percent of VYM are in this sector, creating a huge difference with these funds. Sub–industries in this sector include hotels, restaurants and leisure (4 percent of assets), media (4 percent) and specialty retail (3 percent).

Financials are 16 percent of assets in FDVV, versus only 1 percent in HDV and 13 percent in VYM. Banks are the largest chunk of this at 6 percent of assets.

Technology exposure is solid for a dividend fund, but underweight versus HDV and VYM. FDVV has 12 percent of assets in tech, versus 15 percent in HDV and VYM.

FDVV is substantially and surprisingly underweight consumer staples. This sector tends to dominate dividend funds because it is a steady, reliable and growing source of dividends, but it is the smallest sector in FDVV at 2 percent of assets, compared towith 19 percent in HDV and 15 percent in VYM. It is the largest sector in VYM and almost the largest in HDV.

Finally, healthcare is underweight in FDVV at 6 percent of assets, more than half of which comes from pharmaceutical stocks. In HDV and VYM, healthcare accounts for 15 percent and 11 percent of assets, respectively.

FDVV top 10 holdings account for 25 percent of assets, less than the 32 percent in VYM and the 57 percent in HDV. Exxon (XOM), AT&T (T), Verizon (VZ) and Chevron (CVX) are top ten10 holdings in all three funds.

Income

FDVV is a high-income fund, one that will rely on the energy subsector to deliver growth. Investors who prefer high current income to dividend growth should consider the fund alongside existing ETF options such as HDV and VYM, and ahead of lower–yielding, but faster–growing options such as Vanguard Dividend Appreciation (VIG). In contrast, investors looking for income growth should hold off on FDVV until we see evidence of its dividend growth.

Risk

Investors also must weigh their risk tolerance and time horizon. The inclusion of MLPs adds another additional layer of potential volatility. MLP funds fell more than 50 percent as oil prices declined from 2014 to early 2016. Rising interest rates could present another headwind if there’s no offset from a rebound in energy prices.

Head-to-Head

FDVV is most similar to HDV in terms of yield and portfolio exposure. Investors aren’t taking on more energy risk by swapping from HDV to FDVV. They will substantially increase exposure to consumer discretionary and financials though.

FDVV is not as similar to VYM. While VYM is a high yield fund, it also has a very balanced portfolio because it doesn’t chase yield. Thus, VYM has a much lower yield than FDVV and HDV, but it should be more stable due to greater sector diversification. An investor moving from VYM to FDVV is adding energy and consumer discretionary, while reducing industrials, healthcare and consumer staples exposure.

FDVV is more compliementary of VYM, and will be best used as a replacement for existing high yield positions.

Conclusion

FDVV has less than one–month of history, and while the fund is solidly constructed, we would wait before adding more than a niche position in the fund. There’s no significant yield advantage versus HDV, a similar fund with a long track record. HDV also charges far less, at 0.08 percent in expenses, versus 0.29 percent for FDVV, and it has much greater liquidity. VYM only charges only 0.09 percent, and FDVV isn’t a good replacement for VYM unless the goal is solely higher yield.

Although we focused on VYM and HDV in this article, there are many other dividend funds available. iShares Select Dividend (DVY) has high utility exposure and consumer discretionary as its second–largest sector. Putting DVY head–to–head with FDVV, we like the greater diversification in FDVV, the lower expense ratio (DVY charges 0.39 percent) and what should be a slightly higher yield.

Investors must be mindful of existing portfolio exposure. Those already tapping MLPs or energy sector stocks for yield should consider whether FDVV would add too much exposure.

Finally, while current income is important, growth is key for any investor with a time horizon that stretches beyond a few years. DVY, for example, has a much higher yield than dividend growth ETFs, but its payout growth lagged over the past decade. The longer an investor’s time horizon and the lower the need for current income, the less appropriate is a fund such as DVY or FDVV. Growth–oriented funds such as VIG are the better option. If you have questions about whether any of these ETFs are the right investment choices for you, please call us at 888-252-5372.