Eric Ervin is the CEO of Reality Shares.  Reality Shares creates research-driven, innovative investment products – including ETFs – to help reduce the effects of market noise and emotion on dividend investor performance.

Eric Ervin Reality Shares

Eric Ervin

The company has several new innovative dividend ETFs.  The company’s dividend ETFs should be considered when looking for the best dividend ETFs.  Reality Shares innovative new dividend ETFs include:

  • DIVCON Dividend Leaders Dividend ETF (LEAD)
  • DIVCON Dividend Defender ETF (DFND)
  • DIVCON Dividend Guard ETF (GARD)

Eric Ervin’s interview is below.  My questions to him are in bold.

You have an impressive background, I’m glad to have you on Sure Dividend. Please tell my audience a little about yourself, your career, and your experience creating ETFs and investing in general.

[drizzle]

Eric Ervin: Thank you. I currently serve as President and CEO of Reality Shares, a firm solely focused on dividend growth investing. Before co-founding Reality Shares, I worked at Morgan Stanley for 14 years, building a wealth management franchise as a Certified Financial Planner practitioner and Chartered Financial Consultant.

At Reality Shares we offer a range of alternative ETFs pinpointing and capitalizing on investment in dividend growth and the stocks most likely to increase their dividends, as well as avoiding those most likely to cut their dividends.

The performance of the DIVCON system is very impressive.  How did you come up with this strategy, and what is it designed to do?

Eric Ervin: Across the field of dividend investing, virtually all dividend-based strategies use rear-view mirror results as an indicator of future dividend growth. We wanted to come up with a strategy with a forward-looking focus on future dividend growth rather than using a purely historical look at historical dividend changes.

DIVCON forecasts and ranks a company’s ability to increase or decrease its future dividends by evaluating each firm based on seven quantitative factors, seeking to deliver a more accurate picture of a company’s fiscal health and better predict the probability of an increase or decrease in a company’s dividend over the next 12 months. While past performance does not guarantee future results, in back-tested analysis of the DIVCON methodology from 2001 through 2015, companies rated in the highest tier by the DIVCON index system (DIVCON 5) increased their dividend 96.6% of the time. DIVCON’s unique methodology offers advisors and investors a systematic way to assess dividend growth probability and use this information to make better informed investment choices—with the potential to outperform the market or provide stability in a volatile environment.

As a forward-looking tool, DIVCON offers some benefits compared to the Aristocrats and Dividend Achievers methodologies. For one, companies with long histories of increasing dividends will not offer the same future dividend growth potential compared to younger companies with solid fundamentals. Second, backward-looking strategies like the Aristocrats and Dividend Achievers are much more prone to dividend cuts. For example, during the Financial Crisis, there were 13 dividend cuts from the Aristocrats and 55 cuts from the Dividend Achievers, compared to 0 dividend cuts from the DIVCON Leaders stocks.

Who is the ideal investor for your 3 different DIVCON ETFs?

Eric Ervin: LEAD is designed as a large-cap equity allocation. As a high-quality portfolio of just the companies most likely to raise dividends in the next 12 months, LEAD offers the potential for better downside protection as it holds many of the names that institutional managers are least willing to sell, even during downturns.

DFND offers investors more of a balanced return. It tracks the market but aims to reduce the downside by utilizing a continuous hedged component that shorts the stocks most likely to cut their dividends. DFND is great for investors looking to stay in the markets at all times or seek a solution during market underperformance.

GARD is meant for investors desiring some downside protection when the markets are in a negative environment, while offering upside when markets are positive. GARD was created to allow investors that want an automated portfolio component that can dynamically allocate in and out of the market depending on the market environment alongside a position in the highest quality dividend growers. It is an equity oriented substitute with a defensive aspect.

The DIVCON system had 2 metrics I’m not familiar with.  The Repurchase / Dividend Ratio is one of them.  How does this ratio work; is a higher ratio or lower ratio better for future dividend growth?

Eric Ervin: The Repurchase/Dividends ratio represents the ratio of the company’s allocations to stock repurchases vs. dividend payouts. Contrary to what you may think, a higher ratio is still better in this case as it shows the company has more financial resources available to allocate away from repurchases and into dividend increases.  Considering share buyback programs are more voluntary than dividend payments, if earnings decline, the company with a share repurchase program and a dividend policy, can eliminate the share buybacks in order to maintain the dividend.  The share repurchase program acts as a buffer to the potential for dividend cuts.

The other metric I’m not familiar with is the BBG Score.  Can you explain this metric and how it works?

Eric Ervin: The Bloomberg Dividend Health Score is developed and maintained by Bloomberg. It serves as an alternative metric gauging the overall dividend health of publicly traded companies and is one of the seven factors we include in our DIVCON analysis. It is based on a scale of -100 (unhealthiest) to 100 (healthiest).

What is the expected portfolio turnover of your DIVCON system ETFs?

Eric Ervin: From 2001 through 2015, the average historical turnover was around 71% for the LEAD portfolio, 82% for the DFND portfolio and 97% for the GARD portfolio. Each underlying portfolio is rebalanced once a year in December. However, ETFs are more tax efficient than mutual funds due to the process of how new shares are created/redeemed. When an investor redeems shares of a mutual fund, the issuer must sell securities to raise the cash needed for that redemption this creates a taxable event for all shareholders in the fund. When an investor sells an ETF, it is simply sold to another investor on the open market just like a stock, meaning no capital gains transaction is involved for the ETF issuer, only for the individual participant selling shares. And it’s even more beneficial to ETF issuers when Authorized Participants (APs) redeem shares. Issuers typically pay the AP “in kind,” delivering the underlying holdings of the ETF, avoiding the taxable event. To further illustrate this point, ETF.com compared emerging market mutual funds to emerging market ETFs over the past two decades, and the average mutual fund paid out 6.46% of its NAV in capital gains to shareholders each year, while the average ETF paid out only 0.01% over the same stretch.

The Guard Indicator on your GARD ETF is interesting.  How did you come up with it?  Will you explain in brief to my audience how it works?

Eric Ervin: When developing the Guard Indicator, we sought to create a quantitative market timing system capable of capturing big moves in the markets before they happened through the use of probability. The Guard Indicator works by identifying periods of downtrend across the S&P 500 sectors by analyzing two factors, downside deviation in volatility and the momentum on each of the 11 broad market sectors.

When nine or more of the sectors have a positive Guard Score, the Guard Indicator forecasts a broad market upswing. When eight or fewer of the sectors have a positive Guard Score, the Guard Indicator points toward possible market weakness. Investors can shift to defensive assets or go short during the periods when the Guard Indicator signals a bear market, bringing the potential for improved risk adjusted returns. We wrote a paper describing the precise mechanics and results of the GARD methodology on our www.realitysharesadvisors.com/gard website.  The GARD indicator is by no means perfect, it works on probabilities.  As an example, we tested the methodology back to the 1950s, GARD would have avoided over 65% of the bear markets.

This is the premise behind the dynamic hedge for the GARD ETF. The underlying portfolio securities are based on the DIVCON dividend health model.  The GARD ETF is invested 100% long in the DIVCON Leader stocks when the Guard Indicator shows a positive market environment, and it switches to 50% long/50% short position when the Guard Indicator shows a negative market environment.  Considering that over time, stocks generally go up, this strategy makes a lot of sense: Long when markets are healthy and hedged when market risks are elevated.

All investment strategies go through periods of outperformance and underperformance.  GARD’s historical back test performance is exceptional, but returns this year have lagged the market considerably.  What is the reason for this?  In what environments do you expect GARD to outperform, and to underperform? 

Eric Ervin: Historically, the strategy’s outperformance was due to the Guard Indicator capturing the two major bear markets between 2001 and 2015, the tech meltdown (2000 – 2003) and the credit crisis (2008 – 2009). There are two components to GARD’s performance – market timing (using the Guard Indicator) and security selection (based on the DIVCON dividend health rating system).

From a market timing perspective, the GARD strategy may underperform in the following scenarios:

  • Bull markets with participation from only a few sectors. The Guard Indicator is designed to capture a broad based rally rather than one concentrated in a few sectors. For example, the Guard Indicator underperformed during the Internet bubble from 1998 – 2000
  • When the market is range-bound, for example, ±10% for a prolonged period, then the Guard Indicator may switch on and off, giving false signals
  • The Guard Indicator may not capture extremely sharp drops in the market because it is designed to capture prolonged bear markets

From a security selection perspective, it will typically underperform when lower quality stocks outperform higher quality stocks (e.g., what took place from March through June 2009). Earlier this year investors shifted to a significant “risk-on” approach we saw low quality names in Energy, Utilities and Materials (three of the hardest hit sectors in 2015) rally while high quality names kept pace with the overall market. From February through July of this year, Crude Oil surged 60% and Gold was up 80%. As a result, the low quality short portfolio components exhibited significant positive returns, negatively impacting performance.

What type of weighting scheme (equal weighting, market cap weighting, yield weighting, etc.) do you employ in your ETFs, and why?

Eric Ervin: We use a factor-based weighting tied to our proprietary DIVCON dividend health rating system. The DIVCON system scores and ranks companies based on a weighted average of seven fundamental factors which measure the relationship between historic dividend trends, cash flow and earnings, buybacks, as well as consensus forecasts and external financial ratings. The DIVCON Leaders and Laggards portfolios are then weighted proportionally based on the resulting DIVCON Scores for each dividend paying company in our selection universe. The healthiest dividend payers with the highest DIVCON Scores are weighted more heavily in the Leaders portfolio (the long component), while the unhealthiest payers with the lowest DIVCON Scores are weighted more heavily in the Laggards portfolio (the short component).

Vanguard recently closed its dividend growth fund.  Do you think the large cash inflows into dividend strategies will negatively impact dividend investor performance going forward?

Eric Ervin: Large cash inflows into high-yield based dividend strategies will negatively impact investor performance in strategies, as many high yielding names are currently overvalued based on stronger-than-normal investor demand in the current market environment. As an example, Utilities make up just 3% of the S&P 500 market cap, but many of the largest inflows this year are going into dividend ETFs and funds with as much as a 30% allocation to the sector. However, if investors utilize a forward-looking focus to make investment decisions, we believe dividend growth investing will continue to provide solid opportunities and exhibit strong performance going forward. Ultimately, investors should focus on future dividend growth, not current yield. If earnings continue to slide, the high yield, high payout ratio companies won’t be able to maintain their dividend and the stocks will become even more volatile. We believe investors should take profits now on their high yielding, low quality names, as they have significantly outperformed the market, and then transition those profits into stronger healthier companies with good prospects for future dividend growth.

Where do you see dividend investing headed in the next 10 years?

Eric Ervin: We don’t see dividend growth investing as a recent fad. Dividends in the S&P 500 have risen in the last 40 of 43 years and have grown at nearly 6.5% annualized over this timeframe. This performance is remarkably stable compared to the equity market, where since 1900 there have been 61 bull years and 54 bear years. As dividends tend to grow during bull markets and can compose a large component of total return during low growth market cycles, dividend growth investing should prove a solid investment strategy for the decades to come. The important thing for investors to consider is dividend growing stocks vs. high yielding stocks. Reality Shares research has shown many of the highest yielding names are also the unhealthiest from a fundamental perspective, while dividend growing stocks have historically outperformed dividend maintainers, dividend cutters and non-dividend payers in the S&P 500 since the early 1970s.

Final Thoughts

Thanks again to Eric Ervin of Realty Shares.  Be sure to visit the Reality Shares site here.

I agree with Eric on taking a quantitative approach to dividend growth investing.  I also agree that dividend growth investing is anything but a fad.  Investing in high quality dividend paying businesses when they trade at fair or better prices is ‘common sense investing’.

Whether you invest in individual stocks or ETFs, a dividend growth investing approach (applied systematically) has historically produced favorable results.

[/drizzle]