A Tax-Free Way to Track Dogs of the Dow

In a way, this is a contrarian strategy, since some stocks have high yields because their prices have dropped. It can also be thought of as a value strategy, since paying generous dividends is a trait often associated with value stocks.

Last week Elements, the same company that listed the Rogers' commodity exchange-traded notes, listed an ETN that tracks the performance of the Dow Jones High Yield Select 10 Total Return Index ETN to capitalize on the Dogs strategy.

The Elements Dow Jones High Yield Select 10 Total Return Index ETN offers a couple of advantages to funds that track this index, as well as one noticeable drawback.

As an exchange-traded note, DOD is a debt obligation of the issuer; it doesn't actually own the 10 stocks. Essentially, Elements is making a promise that DOD will return the same as owning the 10 stocks, plus their dividends. ETNs track indices. They don't own anything, nor do they pay any dividends.

There are two distinct advantages to this format. The first is that since there are no dividends paid there is no dividend income to tax. The second is that no matter how much turnover there is in the index, DOD won't sell any stocks, and therefore won't declare any capital gains.

Of course, you will pay tax if and when you sell DOD itself, but a long-term investor can hold this in a taxable account indefinitely without having to pay any taxes -- or at least until the notes mature in 15 years.

The disadvantage is more of a mental obstacle. DOD does not pay dividends. The ETN is supposed replicate the total return of owning the 10 stocks (price appreciation plus dividends less the expense ratio) but it does not own the stocks. Many investors like to see dividends hit their accounts and it may take an adjustment of perception to get comfortable with concept.

DOD will have a 0.75% expense ratio, it will mature in November 2022 and the implied (not actual) yield was 3.58% on October 31.

There are definitely some stocks in this mix that are true dogs, but this is always the case. A back test of the ETN or the index suggests the strategy outperforms the Dow Diamonds TICKER TYPE="EQUITY" SYMBOL="DIA" EXCHANGE="NYSE" PRIMARY="NO"/>, which holds all 30 stocks in the DJIA, with a little less volatility. However, the Dogs strategy was not unscathed by the market meltdown at the start of the decade. So don't buy DOD expecting it will be immune from a bear, or worse, market.

I would note that the backtest for this product is probably the most reliable one of all the "market-beating" funds because the strategy has existed for so long.

In a diversified portfolio, this product could be used as a proxy for either a large-cap or a large-cap value strategy for investors who tend to use broad-based products for their entire portfolios. It could also be used as part of the core portion in a core-and-explore strategy.

The chart of the back test does not capture the inflation of the tech bubble from late 1997 to early 2000, but it is worth noting that the Dogs strategy lagged the broader market as the bubble inflated.

What I think this reveals, not surprisingly, is that in the future, when there is a wide dispersion between growth and value that favors growth, a value-based strategy like Dogs of the Dow should be expected to lag. This is not a knock on DOD; no strategy perpetually outperforms. In fact, the Dogs have outperformed the majority of the time.