Journal of Financial Planning: July 2014
Tom Lydon is editor of www.ETFtrends.com and president of Global Trends Investments, a registered investment adviser. He is a frequent contributor to major print, radio, and television media.
Advisers can gain exposure to stable dividends through exchange-traded funds, but it is also important to look under the hood. As the ETF universe continues to expand, the variety of dividend-related investment options have increased.
Compared to high-flying growth stocks or small-capitalization companies, dividend-paying companies seem like a boring trade. However, these companies tend to be more mature, providing an investment portfolio with a sense of predictability and stability. Combined with a consistent dividend payout, more established companies can produce stable and solid returns over the long haul.
Along with letting investors know about a company’s financial health, dividend stocks help provide greater long-term performance with less volatility. Historically, dividend-paying companies have outpaced non-dividend payers. Adjusting for inflation, dividend income has made up about three-fourths of total U.S. stock market returns over the past 100 years.
Advisers looking into the ETF space to access broad dividend plays tend to steer toward the so-called old guard dividend ETFs, like the Vanguard Dividend Appreciation ETF (VIG), iShares Select Dividend ETF (DVY) and SPDR S&P Dividend ETF (SDY). These three ETFs provide exposure to quality firms that show high profits, low financial leverage, and relatively stable earnings.
However, due to the conservative nature of these strategies, the funds can show relatively low yields. VIG has a 12-month yield of 1.9 percent, DVY has a 3.04 percent yield, and SDY has a 2.24 percent yield.
Dividend Indexing Methodologies
Although they all show a prevailing theme of producing yields, dividend ETFs will achieve their goal in varying fashions. Some dividend ETFs weigh individual stocks by their dividend yield or by total dividend paid in dollar amounts. Others weigh companies by size or market cap.
ETF indices weighted by total dividends paid would lean toward large-caps, because larger stocks issue the highest total dollar amount. Additionally, the large-cap tilt could provide lower volatility in times of market stress. For example, something like the iShares High Dividend ETF (HDV) leans heavily on mega-caps at 69.1 percent of the portfolio, followed by large-caps at 22.8 percent.
As the popularity of dividend-oriented investments grows, more money managers are churning out dividend stock funds to satiate the growing demand. In the persistent low-yield environment, the search for income has led to a boom in what some advisers are referring to as “next-generation” dividend ETFs that follow new, customized benchmark indices.
These next-generation dividend ETFs track so-called smart beta indices that employ actively managed styles with more sophisticated screening processes. Instead of selecting traditional large dividend stocks, smart beta dividend ETFs could screen for factors like highest dividend yield.
Indices that follow a dividend yield-weighted methodology produce more income, but the strategy comes with greater risks. Some funds could lean toward more distressed, high-yield and small-cap firms than other types of broad equity ETFs. For instance, the PowerShares High Yield Equity Dividend Achievers Portfolio (PEY), which has a 3.35 percent 12-month yield, targets companies based on dividend yield, along with consistent growth in dividends. Consequently, PEY includes a heavy 34.3 percent tilt toward small-capitalization stocks, followed by 25.7 percent weight toward mid-caps.
Advisers can also consider an actively managed ETF approach to the dividend theme. For example, the Cambria Shareholder Yield ETF (SYLD) selects holdings based on cash dividends. SYLD also includes stocks with a history of share repurchases and a mandate that constituent companies must also reduce their debt burdens.
While browsing through the dividend ETFs available on the market, look beyond the yield generated and consider how the fund achieves its goals. No two investment strategies are the same, and advisers should know the subtle differences between varying indexing methodologies.