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landmine-ground.jpg Salah Malkawi/Getty Images News/Getty Images

Hidden Land Mines in Dividend Funds

Energy market rout plants potential landmines in value and dividend ETFs. Advisors should beware.

The energy market crash and the subsequent destruction of leveraged and futures-based exchange traded products exposed a problem: Many advisors and investors buy ETPs that they don't understand.

With the oil market creating its own mayhem amid the broader market meltdown, advisors need to look in their client portfolios to sniff out the hidden land mines.

"There are 233 oil-related ETPs in the world, a quarter of which are leveraged," said Eric Balchunas, senior ETF analyst at Bloomberg. He added that a dozen are trading below $1 and hold barely any assets.

With businesses shut down across the U.S. because of the coronavirus, COVID-19, and almost all forms of transportation brought to a standstill, demand for oil dried up like a puddle in the desert. In good times, global demand is approximately 100 million barrels of oil a day, with the U.S. making up 20% of the market.

"Global demand fell by around one third," said Stewart Glickman, senior equity analyst at CFRA, an independent investment research house in New York City. "This is off the charts relative to other recessions or other downturns in the industry. It's not even close. It's a massive sea change for this industry and it cuts across every piece of the value chain."

With demand for crude disappearing, no place to put supply, and a price war between Saudi Arabia and Russia added in, prices fell through the floor.

The May futures contracts traded in negative territory. That means the midstream oil companies, which run the industry's pipelines and storage facilities, had to pay the refineries, or downstream companies, to take the oil from them.

The United States Oil Fund (USO), an exchange traded product that tracks the price of oil, plunged 81% from a Jan. 3 high of $13.18 to $2.51 as of April 22.

Many USO investors thought they were buying oil at the spot price. But the fund doesn't own oil; instead it holds the front month of the oil futures contract. This means that the contract has to be rolled over before the expiration and the fund managers buy the second-month futures contract, which can incur crippling costs.

Many observers expect a wave of bankruptcies across the sector, and some advisors may not be fully aware of the potential damage. A rule of dividend investing is that extremely high yields may indicate that the dividends will soon be cut—companies with cash flow problems often cut their dividends to stay afloat.

"I would tell people to be careful with what the constituent parts of the ETF you own look like," said John Maloney, CEO of M&R Capital Management, a New York City-based registered investment advisor with $450 million in assets under management.

In the broad market, the energy sector shrank by half in recent years, making it the second-smallest sector in the S&P 500 Index. Since 2017, the sector fell from a 6% weighting to just 3% today, slightly more than the materials sector, according to CFRA. Energy makes up less than 2% of the Russell 2000 Index, the small-cap benchmark.

However, energy stocks can be found in larger weightings in a diversified group of ETFs, such as value funds and dividend funds.

For example, the Invesco S&P 500 Pure Value ETF (RPV) holds S&P 500 constituents with strong value characteristics and big dividends, giving it a 4.1% yield. Energy stocks comprise a 12% weighting in the fund, four times more than the broader market benchmark.  

"Some of those stocks are cheap for the right reasons and some are cheap for the wrong reasons," said Todd Rosenbluth, director of ETF and mutual fund research at CFRA—one of those wrong reasons being a highly leveraged balance sheet.

"Dividend cuts is a much bigger issue for ETFs that focus on dividend yield as opposed to dividend growth," said Rosenbluth. With stock prices falling, dividend yields have climbed, making them more attractive but potentially more dangerous as well as those high yields indicate a weakness in the underlying security.

This could be a concern for a fund such as the SPDR Portfolio S&P 500 High Dividend ETF (SPYD), which has a yield of 7.3% and an 11% weighting to energy.

As long as the dividend is not cut, even if the stocks fall in value, the fund will continue to hold them. In an actively managed mutual fund, the manager would get rid of the stock that day, but in an index-based fund, the stock would not be removed until the fund rebalances, hurting both the price and the yield.

Another fund that could experience dividend cuts is the iShares Core High Dividend (HDV), which has a yield of 4.6%. Energy is the largest sector in the fund, with 26% of the portfolio.

Despite the Energy Select Sector SPDR ETF (XLE) holding all the energy stocks in the S&P 500 and nothing else, this might be the best ETF if a client has a burning desire to be exposed to the energy sector.

The fund holds no derivatives, just equities, and should benefit from oil increasing in price—as it inevitably will. Chevron and ExxonMobil hold a 46% weighting in the fund. These integrated super majors have facilities both upstream and downstream in the supply chain and solid balance sheets with little debt. They both pay fat dividends, giving the fund a juicy 14.1% yield.

In this environment, there's a risk any company could cut its dividend, but Glickman said the big oil companies probably won't. With growth investors fleeing the energy sector and ESG investors ignoring it, all these companies have left to offer investors is income. Glickman said these companies would slash capital expenditures and eliminate stock buybacks to protect those payouts.

Investors looking to take advantage of the low in the market may find some protection in that.

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