ETF investing is one of the best financial innovations of our time but themed ETF investing—including the Dogs of the Dow or the eqivalent ETFs on TSX—is a poor investing strategy

Dogs of the Dow, or Dow dogs for short, is not alone, however, with the number of themed ETFs–including ETFs on TSX–expected to grow in 2023 and beyond. Inner Circle members often ask us about themed ETF investing strategies, and most of the time, we tell them we do not recommend investing in themes. ETFs based on the so-called “Dogs of the Dow” stocks are just an example. ETFs depending on the growth of Dow dogs are based on a collection of the lowest-priced, highest dividend yielding stocks that trade on the Dow Jones Industrial Average. The Dow dogs list is updated annually.

Rising interest rates will work against the Dogs of the Dow ETF investing approach

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The ALPS Sector Dividend Dogs ETF (symbol SDOG on New York; www. alpssectordividenddogs.com), is an example of an ETF that applies the “Dogs of the Dow” theory on a sector-by-sector basis using the stocks in the S&P 500. (Note: There are similar ETFs on TSX.)

As we mentioned above, the Dogs of the Dow approach involves buying the lowest-priced, highest-yielding stocks in the Dow Jones Industrial Average. At the end of each year, you pick the 10 stocks from the 30-stock Dow with the highest dividend yields. You then invest an equal dollar amount in each, hold them for one year and repeat these steps annually.

The ALPS Sector Dividend Dogs ETF picks five stocks from each of the 10 sectors as defined by the S&P 500 index—consumer discretionary, consumer staples, energy, financials, healthcare, industrials, information technology, materials, telecommunication services and utilities. The ETF picks the stocks with the highest dividend yields. Each holding is then equally weighted so that every company has a similar influence on the ETF’s total return. The end result is a portfolio of 50 large-cap stocks.

The Dogs of the Dow strategy worked well in the 1990s because interest rates were going down. This tended to raise all stock prices. But high-yielding stocks were affected more than most, because they attracted former bond investors who were switching into stocks.

Interest rates are now likely to remain steady or rise a little more in the fight against inflation–given the price pressures associated with the pandemic recovery. So we see little appeal in a Dogs of the Dow approach, whether it’s this particular fund or similar concept ETFs on TSX.

For that matter, we see little appeal in following any formulaic approach to investing. The one basic rule about things like this is that if it sounds too good to be true, then it isn’t true.

The ALPS Sector Dividend Dogs ETF holds a number of stocks we recommend in Wall Street Stock Forecaster.

It also holds a lot of stocks we don’t recommend. But, more to the point, we don’t recommend using a Dogs of the Dow approach to picking stocks or ETF investing.

There is no “philosopher’s stone” with Dogs of the Dow

In the Middle Ages, people used to dream about getting rich by uncovering something called “the philosopher’s stone”—a legendary material that could “transmute” base metals like copper or lead into gold.

Nowadays, investors dream about getting rich by uncovering the ultimate stock market indicator, or what you might call a “magic key to market profit.” This legendary device tells you which stocks to buy and/or how to buy at the bottom and sell at the top.

Promoters sometimes package a magic key into a set of books, videos or a computer program and sell them for hundreds or thousands of dollars. The Internet is full of offers of tools or indicators that supposedly tell you what stock (or foreign currency, or futures contracts) to buy or sell.

The web page promoting the method usually shows how much money you’d have made if you had followed the rule. It may calculate results that stretch back a year or two, or as much as 50 years or more.

The problem is that these “magic keys” reflect what you might call statistical correlations or anomalies, rather than cause-and-effect relationships. That is what we see in this ETF investing approach, and investors should be wary of this Dow ETF and similar ETFs on TSX.

Three tips for ETF investing

1. Get out of “theme” ETF investing, like Dogs of the Dow, especially when the ETF’s theme seems to be plucked from recent headlines.
   It pays to stay out of narrow-focus, faddish funds, all the more so if they’ve come to market when the fad dominates the financial headlines. Theme funds like these face a double disadvantage, because they appeal to impulsive investors who pour their money in just as the fad hits its peak. This forces the manager to pay top prices—perhaps to bid prices higher than they’d otherwise go—even if this goes against their better judgment. These same investors are also apt to flee when prices hit their lows, forcing the mutual fund manager to sell at the bottom and lowering the ETF’s performance. But when a fad dies out, as they all do, the fund’s liquidity dies out with it. The manager may have to dump the mutual fund’s holdings when demand is at its weakest, forcing prices lower than they would otherwise go.
2. Get out of bond ETF investing.
   Outside of themed investing like Dogs of the Dow, many investors are attracted to bond funds, especially bond ETFs on TSX, which built great performance records a few years ago. But this was a function of the trend in interest rates; when rates fall, bond prices go up. Interest rates are low right now, but moving higher over the next few years as the economy recovers. This is another way of saying that bond prices could fall. When bonds yielded 10%, perhaps it made some sense to buy bond funds and pay a yearly MER of, say, 2%. Now that bond yields are a fraction of that 10%, those MERs have a greater impact on your ETF’s performance. The bond market is highly efficient, and we doubt that any bond ETF’s performance can add enough to offset its management fees. In addition, investing in a bond mutual fund exposes you to the risk that the manager will gamble in the bond market and lose money. Bonds are attractive for predictable income, and as an offset to the stocks in your portfolio. But it’s cheaper to buy bonds directly than to do so through a bond mutual fund. If you want capital gains, buy stocks or stock-market ETFs.
3. Get rid of ETFs that show wide disparities between the ETF’s portfolio and the investments that the sales literature describes.
   Many ETF operators describe their investing style in vague terms. It’s often hard to find out much about who is making the decisions, what sort of record they have, and what sort of investing they prefer. We always take a close look at an ETF’s performance and investments to see if they differ from what the prospectus or sales literature would lead investors to expect. For example, it may suggest broad diversification, but it may in fact hold a disproportionate amount of mining stocks. Our advice: When an ETF takes on a lot more risk than you’d expect, you should get out.

Have you used a specific ETF strategy in your portfolio? Were they themed-based ETFs on TSX? Share your experience with us in the comments.

This article was originally published in 2017 and is regularly updated.