Investors are sticking with dividend ETFs despite the Fed's moves

U.S. lending rates are rising, and investors are holding on to $151 billion worth of dividend ETFs. Cue the sell-off? Not so fast. Even as the Federal Reserve increased interest rates last week for the fourth time since the financial crisis, assets in exchange-traded funds that hold high dividend stocks hardly budged. So far in June, investors have pulled $26 million from the funds, the first monthly outflows in more than a year, but a drop in the bucket for the second-largest smart beta category after value. It seems investors are bucking the conventional wisdom that rising rates mean it's time to get rid of the dividend payers in their portfolios. "While there are definitely some people that go in for yield, there is another dimension here, which is that people simply value stocks that pay dividends," said Eric Balchunas, a Bloomberg Intelligence ETF analyst. "Dividend ETFs really held their own and in some cases took in money during past rate rises," he said. The elephant in the room is that interest rates aren't exactly cooperating with the Fed. In December 2015, before the central bank announced its first hike in nine years, the 10-year Treasury note yielded around 2.27%. On Tuesday, it was 2.16%, according to data compiled by Bloomberg. While traders at the short end of the curve are bowing to the Fed's projected tightening path, longer-term rates are actually falling. "That has eased a little bit of the outflows — the fact that rates are still low and they haven't resumed an upward trajectory yet," said Sebastian Mercado, ETF strategist at Deutsche Bank. There's also the multidimensional appeal of funds like the $24 billion Vanguard Dividend Appreciation ETF (VIG). "We like VIG, not necessarily for the income generation, but rather for the focus on finding ways to access high-quality companies," said Joseph Smith, senior market strategist at CLS Investments. The Vanguard ETF holds around 200 companies that have a history of increasing dividends for 10 consecutive years, excluding REITs. "We've used dividend growth as a measure of quality in terms of how clean the balance sheets are, how consistent the companies are," Smith said. "It's great for a lot of smaller investors, those that might not have a couple-million-dollar portfolio," said Ben Westerman, senior vice president at HM Capital Management. Dividend funds also "hold up better" than the broader market when stocks head south, though they will underperform in bull markets, Westerman said. The buy-and-hold mentality is another reason why fund flows probably won't change much, Mercado said. "Because dividend ETFs are used for more strategic purposes, with fewer tactical players, this segment of the market is less prone to show those tactical shifts," he said. That's despite some puzzling economics. At 1.96%, VIG is yielding less than the 10-year Treasury note and around the same as the S&P 500 Index. "I don't really understand the value" of the dividend ETF, Balchunas said. "Especially because you can get the S&P for almost nothing."