Dividend ETF Investing: Four Critical Factors To Consider

by on October 18, 2011 | Updated December 21, 2012 | ETFs Mentioned:

The proliferation of exchange-traded products offering investors exposure to dividend-focused strategies is a testament to the efficiency of the marriage of this methodology with the inherently appealing exchange-traded structure. The wealth of choices is certainly a luxury, as it allows investors to specifically target the exposure desired. But with dozens of exchange-traded products offering up access to dividend paying stocks, it can be challenging to sort through the entire lineup.

Not all dividend ETFs are created equal, and in fact the differences in the risk / return profile among the products in this segment of the ETF universe can be significant. The nuances of the underlying indexes can be somewhat complex, but can be critically important in determining the yield and volatility that can be expected from these products. This article serves as a guide for the important factors to consider when evaluating potential dividend ETFs, including index weighting methodology, sector biases, and the several metrics that can be used to measure current returns [see 50+ All-ETF Model Portfolios with a free 7-day trial of the Pro subscription].

Dividend Weighting vs. Dividend Yield Weighting

Many of the most popular dividend-focused products out there are linked to indexes that consider cash distributions paid in the process of selecting benchmark components and assigning weightings. The appeal of this strategy can be two-fold; investors avoid the pitfalls of cap weighting while also achieving exposure to securities that make meaningful cash payouts. But it is important to note that there are multiple approaches to dividend weighting, and the differences between the two can be enormous. There are a number of ETFs linked to dividend-weighted indexes, which give the largest allocations to the companies with the largest cash dividends. Because bigger companies will generally make bigger distributions, it is possible that dividend-weighted indexes will be somewhat similar to cap-weighted counterparts [download How To Find The Right Dividend ETF].

For example, of the ten largest individual holdings in the LargeCap Dividend Fund (DLN), seven are also among the ten biggest individual holdings in the S&P 500 Index Fund (IVV). There are also ETFs linked to dividend yield-weighted indexes, which give the largest allocations to companies with the greatest dividend yields. Because there is generally a weaker connection between company size and dividend yield, these products would generally be much more likely to include small and mid cap firms. To understand the difference between these two approaches, consider an ultra-simple index comprised of just two companies:

  • Company A: Market Cap of $100 million, annual dividend of $10 million
  • Company B: Market Cap of $500 million, annual dividend of $20 million
Company Dividend Dividend Yield % In Dividend Wtd. Index % In Yield Wtd. Index
Company A $10 million 10% 33.3% 71.4%
Company B $20 million 4% 66.7% 28.6%
Index Yield 6.0% 8.3%

In a dividend-weighted index, company B would receive the largest allocation, yet the opposite is true with a yield weighted index, by a pretty wide margin. Using the exact same components, the two methodologies result in very different relative weightings and weighted average distribution yields. In other words, dividend weighting and dividend yield weighting are far from identical; the results of these two approaches can be very, very different [see see 101 High Yielding ETFs For Every Dividend Investor].

It should be noted that there is no universally superior approach. Pure dividend yield weighting can result in higher yields, but might also include allocations to more speculative companies (many dividend yield weighted indexes will implement quality screens as well to avoid overly speculative stocks).

Consistency vs. Magnitude

This second topic follows in the same general direction as the first: the nuances of the index construction process can result in drastically different yields across dividend-focused ETFs. In this case, it is important to note that some benchmarks screen potential components primarily on the consistency of dividends, while others are designed to include only stocks with the highest absolute dividend yields. This is an important distinction, as companies that have regularly paid distributions will not necessarily be the same companies that offer the highest dividend yields.

Consider the PowerShares Dividend Achievers Portfolio (PFM), which is linked to the Broad Dividend Achievers Index. To be included in that index, companies must have increased their annual dividend for ten or more consecutive years–a tough test to pass that screens out all but the most consistent dividend payers. But because there is no consideration of yield in the inclusion requirements, PFM won’t necessarily have an eye-popping yield.

Other indexes are designed to maximize effective yield. For example, the Global X SuperDividend ETF (SDIV) examines primarily distribution yield when selecting components (some dividend stability filters are applied as well). The result is a portfolio with a significantly higher yield than many that place an emphasis on stability. Again, there is no universally superior approach; some strategies will value consistency over magnitude, while for other investors the priorities will be flipped. But it’s important to match up your objectives with those of an ETF; crossing wires in this respect can result in significantly less yield or more risk than is desired [see 101 ETF Lessons Every Advisor Should Learn].

Beware Sector Biases

In general, certain types of companies make more substantial distribution payments than others. Companies with more stable operations–such as utilities and consumer staples firms–are generally at the top of the list, while tech firms and consumer discretionary stocks tend to make much lower distributions. As such, there exists the potential for dividend-focused ETFs to maintain sector biases–shifting assets heavily towards one corner of the market while underweighting or avoiding other corners altogether. So when evaluating a potential dividend ETF investment, it is important to take a look under the hood and understand the impact that a sector bias may have on the risk / return profile.

Consider the WisdomTree Middle East Dividend Fund (GULF), a product that targets dividend-paying companies in Qatar, Kuwait, the UAE, and other markets in the Middle East region. About a third of the underlying portfolio is in financials firms, with another third in telecom stocks. So about 60% of assets are split between two sectors of the economy, while other sectors are hardly represented at all. There isn’t necessarily anything wrong with this structure; achieving a more balanced portfolio would likely mean sacrificing yield from GULF. But it’s worth being aware of any meaningful shifts that can have an impact on the volatility or risk profile [see also Africa-Centric Portfolio].

Evaluating Yield

Finally, investors considering dividend ETFs are likely to be interested in the yield offered by a product. But yield is not always a straightforward number; in most cases, there are a handful of different metrics that can be used to quantify the current return that can be expected from a product.

  • 30 Day SEC Yield: This standardized metric, developed by the Securities and Exchange Commission, is based on the most recent 30 day period. This yield metric includes dividends earned over the last 30 days, less any expenses. Because this is a standardized calculation, it is a popular comparative metric for investors considering multiple ETFs.
  • Distribution Yield: This measure of yield reflects the annual yield that would be realized if the most recent distribution stayed constant moving forward. As such, this measure can fluctuate if dividends are made unevenly throughout the year, and is inherently backward looking in nature.
  • 12-Month Yield: This figure simply represents the yield that would have been received if an investors had held the ETF for the previous 12-month period. So there is no need to annualize recent distributions, and this metric should not fluctuate significantly across time. Of course, this metric won’t be available for new products without a lengthy operating history.
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Disclosure: No positions at time of writing.