This publication recently spoke to a West Coast investment house seeking to profit by isolating behavior in dividend payment trends from the stock prices of companies.

Trying to time the direction of markets and those inflection points, such as the start of a possible bear or bull market, is famously said to be a mug’s game, but there is no shame or foolishness in trying to prepare for such eventualities. There is also a need for investors to capture sources of return that can be found through the “noise” of the market.

It is easy to see the attractions of such an approach, given the less-than-stellar performance of markets of late. The MSCI World Index of developed countries shares shows total returns (capital growth plus reinvested dividends) of an anaemic 0.04 per cent since the beginning of January this year. Over the latest three-month period, that index is down 4.24 per cent. It is quite possible that 2015 will prove to be a negative year for the world’s main equity markets. In the US, home to the world’s largest equity market, price/earnings ratios are elevated at 17.5 times earnings, against the long-term historical average of 13.14 per cent. While PE ratios are by no means a fail-safe measure of whether markets are cheap, costly or about “fair value”, the valuation gap makes people nervous.

In such an environment of flat-lining or even negative equity performance, and continued low or even negative real interest rates, the hunt remains intense for investments able to deliver returns.

A firm seeking to deliver such results is Reality Shares, a US-based business that launched an exchange traded fund in December last year with a particular twist. Called the Reality Shares DIVS ETF – or “DIVY” for short – the New York Stock Exchange-listed ETF was created to capture growth in dividends of companies and separate that from the capital values of shares. Reality Shares says on its website: “DIVY is a first-of-its-kind ETF that seeks to deliver long-term capital appreciation based on the growth of dividends, not stock price, of companies included in the S&P 500 index. The DIVY portfolio is constructed using financial contracts designed to eliminate exposure to stock price movements, so the fund does not reflect stock price changes due to changing investor sentiment or exogenous events."

This publication recently spoke to Eric Ervin, chief executive of Reality Shares, a firm that is headquartered in San Diego, CA.

Until DIVY came along, Ervin said, the ability to get targeted exposure to rises of dividends, independent of the price of a security, was only open to large institutions, and not to even highly wealthy individuals. This ETF has opened up a market opportunity in much the same way that other ETFs have done for investors who, say, have previously struggled to put money into emerging markets or sectors such as infrastructure. And the isolation of the dividend factor through an ETF is also an example of the trend of “smart Beta” products in asset management. (Smart Beta describes how an index replicates a style of investing to obtain returns associated with a particular strategy without the cost of active management. These are rules-based investment strategies that don’t depend on market capitalization.)

The ETF changes this lack of access to dividend-focused strategy among private clients, Ervin said. “The main strategies to access isolated dividend growth - without stock price exposure - are dividend swaps, dividend futures and "jelly roll" options combinations. These strategies are typically not economically viable for individual investors, and in the case of swaps, an ISDA agreement for over-the-counter derivative trading is required, and as a 40-Act fund DIVY has preferable collateral agreements to execute swaps,” he said.

At the moment this [DIVY] is on the only ETF that Reality Shares has: more are planned that aim to capture returns from firms most likely to cut or raise dividends, Ervin said. There will be an ETF that takes a long-only approach, one that takes a long/short approach, and one that blends both approaches. Reality Shares has filed with the Securities and Exchange Commission to roll out three new ETFs; it is prevented from commenting on the funds for a period of time, but Ervin explained the indices on which the ETFs are based.

All three indexes have a long position in the large cap companies considered most likely to increase their dividends within 12 months under Reality Shares’ own “DIVCON” methodology. Two of the funds also use short positions to provide a different return profile.

Firstly, the Reality Shares DIVCON Leaders Dividend Index is a long-only index that invests in DIVCON 5 companies, those rated as most likely to increase their dividends; secondly, the Reality Shares DIVCON Dividend Defender Index is a long/short index that invests 75 per cent in the DIVCON Leaders companies, and has a short position of 25 per cent in DIVCON 1 companies, those rated as most likely to cut their dividends. And thirdly, the Reality Shares DIVCON Dividend Guardian Index uses the firm’s “Guardian” market strength indicator to adjust between two portfolio positions.

Ervin explained that when its Guardian measure indicates that the market is expected to rise, its portfolio is long-only the DIVCON Leaders companies. But when Guardian indicates the market is expected to decline – like now - the long position in the DIVCON Leaders is reduced to 50 per cent, and a 50 per cent short position in the DIVCON 1 companies is added. The DIVCON Dividend Guardian Index is a hybrid of the first two indexes, using Guardian to determine the portfolio composition.

Guardian

So what is the mysteriously-named “guardian”? It is a market strength tool that blends analysis of market volatility and trends in price momentum to find inflection points, such as the sign of a bear market forming. In other words, the indices in question are all designed to capture stresses and changes in how markets are behaving from bull market conditions to bear market situations. That’s the theory, anyway.

Ok, so much for the theory and financial engineering-speak: how does this “guardian” work in practice? Ervin said that based on testing of data going back to the 1950s, the indicator has a 67 per cent prediction accuracy. (A measure that has a prediction rate around 50 per cent would not be of much use and one with a rate nearer to 100 per cent might make investors suspicious of such a claim, perhaps.)

“Over the last 15 years this [guardian indicator] has only arisen three times: 2000 to 2002; in 2008, and now,” Ervin said.

Ervin brings plenty of investment and market experience to this company, which was formed in 2012. He previously worked at Morgan Stanley and Smith Barney. He was an investment manager and financial advisor for high net worth and ultra HNW clients, with a particular focus on alternative investments.

Performance

So, how has the DIVY ETF performed? Since December, 18, 2014 (the inception date), it is up 3 per cent, contrasting with declines in the broader stock market.

The ETF, Ervin said, aims at a consistent return for those who want a market-neutral exposure, and therefore valuable for wealth managers. “This is targeted at wealth managers, ultra high net worth individuals, family offices….it is perfect in that regard,” Ervin said.