Are Dividend ETFs the Best Income Alternative?

Dividend investing never goes out of style. Over the past 100 years, dividends have accounted for some 47 percent of the S&P's total return.

Lately, investors are combining their hunger for yield (paltry bond and some equity yields continue to disappoint) with the popularity of exchange-traded funds (ETFs). The category they're increasingly tapping includes dividend ETFs and specialized high-dividend ETFs.

[See top-ranked ETFs by category ranked by U.S. News Best ETFs.]

"Beyond individual securities, investments in equity ETFs [that] have stocks that pay high dividend yields emerged as a source of decent income for investors at this time," said analysts at Zacks Investment Research, in a commentary. "This has proven to be a pretty good strategy as intermediate-term bonds are still yielding below broad stock markets and equities are rising so far in 2012."

Market uncertainty leads to increased inflow to dividend ETFs, which can help boost their return. But investors should be paying attention to consistency in dividend payment and the financial strength of the companies paying the dividends.

Better than other income sources? "While dividend-focused ETFs may be safer than other equity funds, they are by no means risk-free," the Zacks analysts stress. "These securities still have market risk and can experience more volatility than their bond cousins. There is always the risk that dividends could be cut if a company runs into trouble. Bond investors are more likely to see their payments paid out on a regular basis thanks to their improved position [bondholders are given payment priority should the issuer face] a liquidity issue."

Do investors get any more value with dividend ETFs or are straight-up dividend-paying stocks the way to go?

ETFs can bring simplified diversification to balanced portfolios. As with any ETF, investors are wise to compare expenses of any one fund to the broader category. Investors must do their homework. It's not enough to find "dividend" in the title and jump.

For instance, "contrary to its name, Vanguard High Dividend Yield Index ETF (VYM) has historically yielded only about 1 percentage point more than the S&P 500," notes Morningstar's Samuel Lee in his coverage of the fund. "Characteristically, Vanguard opted to market-weight the fund's holdings, so mature, higher-quality firms like Exxon Mobil (XOM) and Microsoft (MSFT) dominate the roost. This may disappoint yield-seekers, but it lends the fund a more cautious posture than many other dividend funds. It would serve ably as a core holding."

[See Should You Have ETFs in Your Portfolio?]

Beyond cost, some critics of dividend-concentrated ETFs argue that they can be too restricted to certain sectors, ignoring others. They may, for instance, be underweight in technology and energy shares. Proponents largely say, so what? If the goal is dividend yield, it may matter far less what types of companies are generating that payout.

Keep in mind that companies typically pay dividends when they don't need to reinvest the cash. Businesses in higher-growth industries will use that cash to expand the company. Investors looking for energy-sector yield may opt for income-generating ETFs that are more specialized. Guggenheim Multi-Asset Income ETF (CVY), for instance, tracks the Zack's Multi-Asset Income Index. It is currently energy-focused and includes Williams Co. (WMB), Spectra Energy (SE), and Chevron (CVX). Managers dig deeper than standard stock plays to generate income. They also select from real estate investment trusts (REITs), American Depositary Receipts (ADRs), and Master Limited Partnerships (MLPs).

More to choose from. Investor demand for dividend ETFs brought Russell Investments to the table with two new high-dividend ETFs earlier in March. Their release offers investors a snapshot of the characteristics that go into stock-picking for these funds. It's a good primer for dividend ETFs in general.

The company designed the Russell High-Dividend Yield ETF (HDIV) and Russell Small-Cap High Dividend Yield ETF (DIVS) to replicate the performance of the U.S. Large Cap High Dividend Yield and Russell U.S. Small Cap High Dividend Yield indexes, respectively. Fund metrics aim to uncover companies that have the capacity to pay out more in dividends and grow their current payouts, while still having strong earnings. They measure the cash flow generation capacity of the company, return on equity, and expectations for future earnings.

By using this method, Russell looks to bring greater transparency to the stock selection approach while avoiding some of the pitfalls that hit many other products in the space, they said. For example, many other funds concentrate solely on high yields without any scrutiny on financial strength, a situation that can lead to trouble if payouts start to become in danger, they said.

Zacks analysts note: "The concentration risk in HDIV seems to be very high with 50% of asset invested in the top 10 holdings of the company, indicating the fund is not very well spread out. The fund will charge a fee of 33 basis points a year, roughly in line with other products in the space. DVIS, meanwhile, holds a total of 150 stocks with expense ratio of 38 basis points."

[See 3 High-Yielding Fixed-Income Investments.]

A few other dividend ETFs to consider:

Vanguard Dividend Appreciation Index (VIG) tracks companies that have grown their dividends for 10 consecutive years. At nearly $11 billion in assets, it has low annual expenses of 0.18 percent. Its market-matching 2 percent 12-month yield reflects its "safer" approach.

SPDR S&P Dividend (SDY). Quality and distressed companies combine in this fund's 60 highest-yielding stocks of the S&P 1500 that have raised their dividends every year for the past 25 years. With $9.3 billion in assets and a 0.35 percent expense ratio, the fund has a 12-month yield of 3.11 percent.

WisdomTree LargeCap Dividend Fund (DLN) takes a different weighting approach, including only stocks of companies that pay cash dividends weighted in proportion to the dividend payout. The ETF's top holdings include AT&T (T), Exxon Mobil (XOM), Microsoft (MSFT), and General Electric (GE). The ETF has a current dividend yield of 2.6 percent and a very low 0.3 percent expense ratio.

PowerShares Dividend Achievers Portfolio (PFM) is linked to the popular Broad Dividend Achievers Index, which focuses on companies that have increased their annual dividend for 10 or more consecutive years. Top holdings include IBM (IBM), Procter & Gamble (PG), AT&T (T), and Johnson & Johnson (JNJ). The ETF has a current dividend yield of 2.1 percent and an expense ratio on the high side at 0.6 percent.

iShares DJ Select Dividend Index Fund (DVY) tracks the top dividend payers, has some $10 billion in assets, and a 12-month yield of 3.37 percent. Expenses are 0.4 percent. "This fund's fat yield comes from smaller, beaten-down stocks. However, too fat a yield indicates the market's skepticism as to whether the payout is sustainable--and the market is usually right," notes Morningstar.

FirstTrust Dow Jones Global Select Dividend Index Fund (FGD) offers international exposure because it tracks an index that aggregates 24 developed-country benchmarks. Only companies that pay current dividends are considered. The ETF has a current dividend yield of nearly 4.7 percent. Its expense ratio is up there, too, at 0.6 percent.

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