Are Dividend ETFs the Best Income Alternative?

April 05, 2012|Rachel Koning Beals | U.S. News & World Report






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.