The Best Dividend ETFs Aren’t Dividend ETFs At All

by on September 27, 2011 | Updated November 20, 2012 | ETFs Mentioned:

As the ETF industry has expanded rapidly in recent years, the universe of asset classes and investment strategies accessible through the exchange-traded wrapper has increased dramatically. In addition to funds offering exposure to natural resources and volatility–two asset classes previously beyond the reach of many investors–a number of products have popped up that seek to deliver opportunities to tap into intriguing investment methodologies in a cost efficient and time efficient manner [see Free Report: How To Pick The Right ETF Every Time].

One area of tremendous interest focuses on dividends; there are literally dozens of ETFs that are designed to concentrate exposure on dividend-paying stocks, from those linked to dividend-weighted methodologies to those with stringent consistency requirements for inclusion. Popular equity funds in the space include DOD, IDV, and HDV; while products with international flavor like PID, DWX, and EDIV can help investors expand the geographic scope of their portfolio’s holdings.

Dividend-focused ETFs may be appealing to a number of different types of investors. For those seeking relatively low risk equity exposure, dividend-focused strategies allow for a dialing back of risk while still keeping a toe in the water. For those seeking to beef up current returns with bond yields at all time lows, some of the yields paid out might be rather attractive [try the Free ETF Analyzer Tool].

For investors seeking broad-based stock exposure tilted towards companies with the highest dividend yields, funds such as VIG and DTD might be good fits [see Dividend ETF Special: 25 Equity ETFs With Attractive Distribution Yields].  But for those looking to max out current yield, there are a number of other exchange-traded products without “dividend” in the name that are capable of delivering much more handsome returns:

MLP ETFs (And ETNs)

The Master Limited Partnership (MLP) sector has been seeing a surge in popularity thanks to the robust growth of the ETF industry, which has allowed for cost-efficient exposure to this unique corner of the domestic energy market. MLPs generate fee-based revenues as they own and operate energy infrastructure assets such as natural gas storage tanks and crude oil pipelines [see Do You Need An MLP ETF?].

MLPs have taken on appeal largely thanks to their favorable tax treatment, allowing for investors to rake in a hefty current income. By generating at least 90% of income from natural resource-based activities (such as transportation and storage), an entity can qualify as an MLP and not be taxed as a corporation. In other words, shareholders of MLPs are treated as partners by the IRS, allowing for investors to avoid double taxation of earnings.

There are several offerings in the MLPs ETFdb Category, and with this asset class in particular, the choice of product structure is very important as the tax nuances between ETFs and ETNs can be significant [see MLP Exposure: ETF or ETN]. Below we have briefly highlighted two of the products available to investors:

  • ALPS Alerian MLP ETF (AMLP): This fairly new ETF has been quite popular as it has amassed more than $4.3 billion in assets since its launch in the latter half of 2010. AMLP tracks the Alerian MLP Infrastructure Index, and its underlying portfolio is comprised of 25 components, with two-thirds of all assets going to the top ten holdings alone. The top three MLPs represented in the fund include Enterprise Products Partners, Kinder Morgan Energy Partners, and Plains All American Pipeline. AMLP recently had an annual dividend yield of 5.98%.
  • JPMorgan Alerian MLP Index ETN (AMJ): This ETN is the largest products offering investors access to the energy MLP sector. The ETN structure gives it a potential leg-up over comparable ETFs in the space since shareholders of AMJ are faced with less administrative burdens by avoiding an annual K-1 tax form [see MLP ETFs: Fact And Fiction]. AMJ recently had an annual dividend yield of 4.9%.

BDC ETNs

Business Development Companies (BDCs) are generally involved in lending money to small and mid-sized companies, often times resembling private equity firms. Similar to MLPs, these entities are eligible for some advantageous tax treatments when certain portions of earnings are paid out. BDCs pay almost no corporate taxes as long as they pay out at least 90% of their profit and capital gains as taxable dividends. BDCs can also earn exemption from the 4% nondeductible federal excise tax if they distribute at least 98% of ordinary income each calendar year [see Actionable ETF Trading Ideas].

This asset class boasts a juicy yield and is particularly appealing since it offers exposure to private companies that are simply not accessible to most investors. Achieving exposure to this asset class through an ETN may have some unique tax consequences as the coupon payments from BDCS will be treated as ordinary income for tax purposes [see Tax Advantages Of ETNs]. There are currently two products available offering exposure to BDCs:

  • UBS E-TRACS Wells Fargo Business Development Company Index (BDCS): This ETN holds a portfolio of 28 BDCs, although it effectively offers exposure to more than 1,000 privately held companies through the broad-based portfolios of the component companies. Also as mentioned previously, investors have no direct way of accessing this asset class since the companies are not publicly-traded. BDCL provides investors with 2x monthly leveraged exposure to the same index as BDCS, which recently had an annual yield in the neighborhood of 7.1%.

Mortgage REIT ETFs

Mortgage REITs are often overlooked by many given then ongoing anxiety over the health of the U.S. housing market. Although quite risky, this asset class is very capable of generating impressive returns for investors looking to beef up the current income portion of their portfolios [see also Monthly Dividend ETFdb Portfolio]. Mortgage REITs are different from traditional equity REITs; instead of owning and operating physical real estate, mortgage REITs issue mortgages or acquire loans and other mortgage-backed securities. It isn’t uncommon for mortgage REITs to leverage up to seven or eight times their capital, allowing for significant distribution yields. Some interesting offerings include:

  • iShares FTSE NAREIT Mortgage REITs Index Fund (REM): This ETF is linked to an index that measures the performance of the residential and commercial real estate, mortgage finance, and savings associations sectors of the U.S. equity market. REM holds a shallow basket of 50 securities, with the top ten components accounting for over two-thirds of the entire portfolio. This fund does a very nice job of rounding out exposure to small and mid cap size mortgage REITs, and it recently had an annual yield of about 11.7%.
  • Van Eck Market Vector Mortgage REIT Income ETF (MORT): This new fund tracks the Market Vectors Global Mortgage REITs Index, and requires that the constituent companies derive at least 50 percent of their revenues from mortgage REITs. MORT holds a portfolio of about 25 different REITs, with the largest allocations going to Annaly Capital Management (about 20%) and American Capital Agency Corp (14%).

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Disclosure: No positions at time of writing.