Journal of Financial Planning: August 2015
Matt Hougan is president of ETF.com, where he oversees the company’s editorial, data and analytics efforts, and conferences.
With bond yields at record lows, investors are increasingly turning to dividend-focused ETFs as a primary source of income. More than 85 dividend-focused ETFs are now on the market with more than $160 billion in combined assets under management, and those numbers are growing.
Here are a few critical questions to keep in mind when choosing these ETFs.
Are You Searching Exclusively for Yield?
Investors typically buy dividend-focused ETFs to earn income or to access strong total returns. Understanding which your clients are going for is critical to finding the right fund.
A swath of ETFs focused on searching for yield tend to hold narrow portfolios (50 to 100 securities), making big bets on the market’s highest-yielding stocks. They often weight those securities by yield or weight them equally to emphasize the highest-paying stocks.
The sine qua non of this approach is the Global X SuperDividend ETF (SDIV), which holds 100 of the world’s highest-yielding securities weighted equally. SDIV doesn’t look for companies with rising dividends, it just buys stocks paying fat yields.
Yield-hungry funds tend to take extreme bets against the market; SDIV has more than 55 percent of its portfolio in financial stocks, for instance. It also owns troubled firms; its largest holding is Evergrande Group, the most levered developer in China.
Some studies suggest super-yielding securities like Evergrande perform well, but they can go through long periods of severe underperformance, introducing significant risk into the portfolio.
Are You Looking for Total Return?
A fund like the Vanguard High Dividend Yield ETF (VYM), in contrast, holds any company paying above-average dividends, so long as that stock is forecast to pay a dividend in the next 12 months. Over long periods of time, stocks that pay strong dividend yields have been shown to deliver strong excess returns.
Consider this data from work by WisdomTree and Jeremy Siegel: divide the S&P 500 into five quintiles holding 100 stocks each. If you invested $1,000 into the lowest-yielding quintile of stocks in 1957, rebalancing annually into the new set of the 100 lowest-yielding stocks, you would have ended up with about $109,000 in 2012. An investment in the highest-yielding securities would have delivered nearly $678,000.
Unfortunately, no ETF issuer has launched a “highest-yielding stocks in the S&P 500” ETF. But still, you can get pretty close. Funds like VYM aim to capture this kind of long-term outperformance by holding a broad-based portfolio of dividend-paying stocks, but focusing on firms with strong economic positioning, VYM uses forward-looking dividend forecasts to ensure that the companies in the index are doing well enough to sustain their dividends. The resulting portfolio boasts a much smaller yield than SDIV, but is much closer to standard market cap exposure.
Aristocrats vs. Aggressive Payers?
Assuming you’re searching for total returns, not yield, the next question is how much risk you want to take. Dividend-focused ETFs include funds that hold any stock with a dividend and a pulse, and funds that focus exclusively on firms with long histories of paying rising yields.
The SPDR S&P Dividend ETF (SDY) will only hold companies that have raised dividends for 20 consecutive years. The resulting fund focuses on companies like AT&T and Consolidated Edison, and has lower risk than the overall market.
The WisdomTree Total Dividend ETF (DTD), by contrast, holds any stock with a dividend and weights them by the amount of cash each firm pays out. Apple, which paid its first dividend in 2012 and won’t be eligible for SDY until 2032, is its largest holding.
Choosing the Right Fund
The most important thing to note is that even though these funds all have “dividend” in their name, the portfolios they deliver—and the returns they promise—vary widely.