Insights on Dividend Growth Strategy From Eric Ervin, Co-founder & CEO of Reality Shares

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Dividend.com: Tell us about yourself and the trajectory that led you to Reality Shares.

Eric Ervin (EE): I started my career at Morgan Stanley as a financial advisor, and I spent about 15 to 20 years in that business taking care of the financial planning and wealth management of individuals and high-net-worth investors.

After that, I managed a lot of individual stock-based strategies on a quantitative basis, and I put money into a lot of alternative investments. At that time, one of my clients had asked me if I would be willing to take some of those strategies and put them into ETFs and start a company. The strategy was fairly unique. It was only available to institutional investors, however, my neighbor couldn’t invest in it. So, I thought, “You know what? I’m ready.”

I left Morgan Stanley in 2012 and started Reality Shares. In the ETF business it takes a good two to two and a half years to create the underlying infrastructure and regulatory business before you can even launch your first ETF.

Towards the end of 2014, we launched our first product, which is very unique. The DIVS ETF (DIVY) is based on the dividends swap market. It’s investing in is the growth rate of dividends of the market and not the stock prices. So all it’s capturing is the dividend growth rate. If dividends rise, DIVY would benefit. If dividends fall, DIVY is going to get hurt. But DIVY doesn’t care if the stock market goes up or down on any given day. DIVY is more like a diversifier and an alternative return provider.

It is the only fund in its category that individual investors can access. So it’s an interesting and unique investment, and, from a return perspective, dividends have only gone down three times in the last 40 years. Dividends tend to be really stable.

However, as a result of focusing on dividends, DIVY is not going to earn you a huge return. When the stock market goes up 20%, usually dividends only go up by 6-7%.

Now DIVY has a nice long four-year track record. This December, it’ll have a five-year track record.
 
Dividend.com: Why do you focus on dividend growth strategies? And could you also talk about your proprietary dividend health rating system, DIVCON?

EE: We wanted to build out a quantitative system to measure which companies had the highest potential for dividend growth. This is simply because there are a lot of strategies out there that invest in dividend growth stocks.

Usually, most of those strategies like the Dividend Aristocrats or the Dividend Achievers are looking in the rear-view mirror and saying which companies have the longest track-record of growing their dividends for 25 years, or 10 years in the case of the Achievers. But the problem is that they’re not really growing their dividends, because they’re mostly the older and more established businesses that don’t have a lot of growth. Even if they grow it by a penny then they’re still considered an Aristocrat.

We found that a lot of the return comes not from “Did you grow your dividends?,” but from “How much did you grow your dividends?” So, we wanted to create a system that could predict the companies with the highest potential for dividend growth. This is more of a windshield approach rather than a rear-view mirror approach.

That led us to the DIVCON system. DIVCON stands for dividend condition. It’s kind of a play on DEFCON.
We rank every company based on seven factors, and we share all of this data and information on our website. You could even just type in DIVCON on Google and it’ll probably pull up the database where anyone can type in any stock.

We rank each company based on seven factors, which we’ve found to be the most predictive for dividend growth. The top tier represents the category of leading dividend growth companies that have never cut their dividends. In fact, the average dividend growth rate of those companies is almost double that of the Dividend Aristocrats, Dividend Achievers and the S&P 500.

It is interesting to note that the Dividend Aristocrats and the Dividend Achievers have lower dividend growth rates than the S&P 500 as a whole, because they’re not picking up those higher growth companies. For instance, financials sector companies won’t even feature in the Dividend Aristocrats for another 10 or 15 years, and that’s really where a lot of the dividend growth has been.

That’s the beauty of the DIVCON system. First, we rank companies based on our system and then we select them. We have three ETFs based on our protocols. One of the ETFs, i.e. LEAD, targets the leading dividend growth companies. The other two will take a long position in the leading companies and a short position in the companies that have the highest potential for a dividend cut. So, that defines the strategies of DFND and GARD.

As it turns out, it’s a really robust strategy. Over the past 19 years or so, there has never been a cut in the DIVCON five category, and then in the DIVCON cutters, usually about a third of them will end up cutting their dividends in the next 12 months.

Be sure to click here to know more about dividend growth strategy.
 
Dividend.com: Recently, the Federal Reserve signaled a pause in rate hikes in early 2019. Since then, we have seen a renewed interest in dividend strategies and stocks. How do you evaluate the current market environment? Do you think it’s a positive for the dividend payers in the foreseeable future?

EE: I think it’s a big positive for dividend growers and dividend payers. However, I want to separate these 2 categories. If interest rates start to rise that is a bad scenario for dividend payers as a whole. On the other hand, it is the dividend growth stocks that stand to benefit the most, because, just like variable pay bonds, they have the potential to increase over time.

The trade-off is that you’re willing to receive a lower yield. But, as it turns out, that is almost always a better trade-off. It is like taking the path less traveled, because it is usually the better path. Those companies with lower yields but higher growth almost always outperform over time. In that regard it offers a good trade-off.
But, if you’re an investor who looks to almost trade the market, then you are betting on what the Federal Reserve is going to do. Under that scenario, you might be able to stay in some of these higher-yielding companies for a little longer because you are willing to trade out of them if there’s any hint of additional interest rate hikes.

Therefore, I think it’s a dangerous place to be. There are some really strong performers. Right now, the yield on even the highest-yielding dividend stocks is not that attractive. So, it’s a hard one to play.
I would stick with the dividend growth stocks wherein the companies have the highest potential to deliver. For instance, consider some of the tech companies. They have been wonderful dividend growers and some of the best dividend paying companies from a performance standpoint.

It is not like the dot-com days where the fundamentals weren’t there. Now you have a lot more strength and healthy balance sheets.

Dividend.com: Last month, we saw the launch of an ETF that will be paying 15 cents for every 1,000 dollars invested. When the ETF grows to $100 million, the ETF will charge 0.29% from the second year onward. First, do you think we are testing the boundaries of what’s sustainable to attract fund flows? Second, what trends do you see driving the fees in the currents markets?

EE: That’s a great question, and I think yes, we are approaching the boundaries on that. I think that the pendulum will continue to shift where, in the absence of value, fees really are important and may become the only issue.

But as more people continue to offer plain vanilla products (i.e. what we call beta in the investment business), which is just exposure to a cap-weighted basket of stocks as an example, then you almost have to offer no fees.

It is not an easy business. It is very expensive to operate. If I had to guess, on average, it takes about $250,000 in fixed costs every year to launch an ETF.

In my opinion, we’ll see more fund closings as companies try to offer really low-cost ETFs, if they can’t get traction. As a result, they will end up closing the fund. But I think that is healthy, because it provides more opportunity for innovation and for society, in general, to have more options. I don’t worry about people shutting down an ETF. There is a very orderly process to wind down ETFs.

As far as the higher value-added funds are concerned, I think that they’re going to continue to see fee compression as well, but it won’t be to zero. So, if it is just a straight large-cap, smart-beta type of a product the fees should be in the range of 30 to 50 basis points.

If it has alternative exposure like long/short there are more costs associated, but it would still be half that of mutual funds. If I was a mutual funds issuer. I would be very concerned. In fact, they have been concerned because of large outflows to the ETF industry year in and year out, as ETFs have proven to be a much better vehicle to gain exposure to equities, bonds and other alternative asset classes.
 
Dividend.com: Lately, we are also seeing more actively managed ETFs coming out. What are your thoughts on that?

EE: Being quantitative in nature, I have invested in both actively managed and passive strategies. But most of the time, even with my own personal investments, I have preferred to have a strategy and a rules-based system to avoid mistakes. Most of the active strategies that are out there could be processed in rules.
And that’s what we did with the DIVCON system. We essentially created a rule set for picking stocks and then we fitted an index around that. For most active money managers that would be their secret sauce. We just decided to make it completely transparent and put a rules set and an index around it and then launched an ETF based on that index.

But there are some ETFs that have to be managed in an active way. For instance, our DIVY ETF invests in the dividend stock market. So, there is no way you could create an index around that – it has to be active. I do think there is going to be some need for active management, but even then we manage by some rules. We just don’t have a published index.

As far as the transparent vs. semi-transparent vs. non-transparent debate goes, I am of the belief that they are just a bunch of fears that the active managers have for going over to ETFs. I don’t really think non-transparent or semi-transparent ETFs are really going to be a thing. I think the trend will just continue towards transparency on a daily basis and having a more transparent system.

Finally, I don’t think there is a lot of value in timing the market or being the front runner. Also, money managers are unlikely to offer a ton of value in a hedge fund or something where you’re trading kind of weird, small esoteric assets.

Dividend.com: Current income and dividend growth are two different dividend-focused strategies. What we have observed is that higher yield gets more investor attention than dividend growth, even though research suggests that dividend growers have outperformed the markets. How important is the role of investor education?

EE: Yes, this is such a big topic, and again, I think it is on us as an industry to really provide a lot of that education. I used to do this even with financial clients, where I would say it’s not about the yield that your portfolio produces. When Harvard or Yale or any endowment or pension fund invests, they don’t try to create the current yield from their portfolio. What they do is try to create a portfolio based on total return and then take a percentage out of that portfolio, even if that means selling some of the assets and rebalancing on a regular basis.

And that’s exactly how people need to think about dividend stocks. It’s not about the dividend income. Dividend is just a measure of whether or not the company’s earnings are real, in my opinion. That is where Reality Shares gets its name; it’s because dividends are real. You can’t fake a dividend. It’s a measure to evaluate whether or not the company genuinely has earnings.

And what do you want when it comes to earnings? You want earnings growth. So, it’s not about just paying out a dividend. You might as well buy a bond for that matter. It’s about the growth of that dividend, because that is likely to rise when the stock price rises. If you have a rising stock price and a rising income stream that’s way better than just having a flat stock price and a flat income stream.

There is one thing we know for sure – inflation is not going away. So, it’s critical for investors to shake their minds up.

But, again, it’s on us as an industry to try to explain that in so many different ways.

Eric Ervin helped us understand that a lot of returns come not from “Did you grow your dividends?” but from “How much did you grow your dividends?” He also spoke about the importance of educating investors on dividend growth strategies.

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