Not all dividend ETFs are created equal, 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, and are 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.
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|
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.
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.
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.
Be sure to check out our Africa-Centric Portfolio.
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.
The Appeal Of Dividend ETFs
Perhaps the most obvious appeal of investing in dividend paying stocks is the fact that they generate a current return, which can help to enhance your portfolio’s risk-adjusted returns over the long haul. Dividend paying stocks tend to bear a lower degree of risk than non-dividend paying ones since investors are more willing to hold onto their positions through both bear and bull markets, given that they receive regular cash payments.
Another advantage of the dividend investing strategy is that this approach has a tendency to avoid stocks of fraudulent companies, since its a lot easier for companies to manipulate earnings, but there is no substitute for cash payouts made directly to investors–dividends are hard to fake.
Why Are Dividend ETFs So Popular?
The ETF boom of the last several years has provided investors with options for accessing new asset classes and pursuing various investment strategies previously inaccessible to smaller retail investors. Evolution in the ETF industry has brought forth numerous options for investors in pursuit of yield. The exchange-traded product wrapper allows for low-cost, low-maintenance exposure to virtually any corner of the market, allowing for investors to access techniques that may be too difficult, or costly, to implement on their own.
See also How To Find A High Dividend ETF.
There are dozens of funds available that offer exposure to dividend paying companies, including both explicit dividend-weighted products and others that focus on sectors that have a tendency to make hefty payouts. Many of the popular dividend ETFs are linked to indexes that consider cash distributions paid in the process of selecting benchmark components and assigning weightings. This strategy may appeal to investors who wish to stray away from traditional cap-weighted products, while also focusing on securities that make meaningful cash payouts. There are also a number of ETFs that select and weight holdings based on dividend yield consistency rather than just magnitude [read more: Details Of Dividend ETFs: Consistency vs. Yield].
How To Use Dividend ETFs
Dividend ETFs have a place in nearly every investment portfolio given the versatility of the products offered in the space. Below we briefly highlight the most popular uses of dividend paying funds:
- Enhance Yield: Interest rates remain at record lows, and with no foreseeable rate increases in the near future, many investors are finding it hard to construct a portfolio that delivers attractive current income without taking on excessive amounts of risk. With interest rates on investment grade fixed income securities near zero, investors who require a constant stream of payments from their portfolios have embraced dividend ETFs [see The Best Dividend ETFs Aren’t Dividend ETFs At All].
For those seeking to beef up current returns with bond yields at all time lows, some of the yields paid out by the dividend ETFs covered in this report might be difficult to pass up. When considering the chart below, notice the significant difference in yield between dividend products, like (SDIV ), and U.S. Treasuries. Dividend ETFs even rival the yields offered in the junk bond space, as represented by (JNK ).
- Scale Back Risk: While some investors pursue value strategies regardless of the economic environment, others view dividend paying equities as the first level of safe haven investing. When mild signs of economic turmoil emerge, investors tend to gravitate towards stocks that provide a meaningful current return in lieu of those the offer potential for significant growth and capital appreciation. 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.
Bu sure to check out the The Top 25 Highest Dividend Yield ETFs.
In the table below, notice how consistent dividend paying stocks, as represented by (VIG ), maintain lower volatility than the S&P 500, while also generating a current return for shareholders. Overall, dividend ETFs have a lower beta than most other equity funds, resulting in a unique risk/return profile that may potentially enhance your portfolio’s risk-adjusted returns over the long haul.
The Bottom Line
Dividend ETFs can be powerful additions to your portfolio, but always be sure to look under the hood to ensure you know how the fund operates and makes its payouts.
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