With the boom years of the 1980s and 1990s now a distant memory, it is not shocking to see investors losing faith in the cult of capital gains and gravitating instead to dividend-paying stocks and ETFs. In a world in which paper gains can be ephemeral, it’s good to be paid in cold, hard cash.
In many ways, this is simply a return to the basics of investing. Historically, before federal capital gains taxes and Modern Portfolio Theory shifted the industry to a focus on growth, dividends were the primary source of investor returns (see Figure 1), and over the past twelve years dividends have been the only source of investor returns.
Today, we have our choice of a host of dividend-focused ETFs—so many, in fact, that it can be daunting to choose. Though all claim dividends as the central piece of their investment mandate, there are significant differences between the strategies that investors should understand. In this article, I’m going to pick apart some of those differences.
There are already well over a dozen dividend ETFs that focus on the U.S. market, and I included the most popular in Figure 2. Each can be grouped into one of three major categories:
- High dividend yield
- High dividend growth rate
- Dividend weighting
The first category is what most investors immediately think of when they hear “dividend investing.” The primary focus is on high current income with capital gains as a distant secondary objective. This is good, old-fashioned “widows and orphans” investing and is the most conservative of the three strategies.
The iShares Dow Jones U.S. Select Dividend ETF (NYSE: DVY) is the oldest dividend-focused ETF and is the only one to follow a pure high-yield strategy. The fund represents America’s top stocks by dividend yield, selected annually. To weed out those at risk of cutting their dividend, companies must have a positive five-year dividend-per-share growth rate and a dividend payout ratio of no more than 60% of earnings. The stocks that qualify are then ranked by dividend yield and the top 100 are selected.
The result is a solid ETF that currently yields more than the 10-year Treasury with an expense ratio and turnover that are tolerably low.
The second category is based less on dividend yield and more on the growth rate of dividends. The PowerShares Dividend Achievers ETF (NYSE: PFM) and Vanguard Dividend Appreciation ETF (NYSE: VIG) are based on rival (yet nearly identical) versions of the Mergent Dividend Achievers Index. To become eligible for inclusion in the Index, a company must have increased its annual dividend for the last ten or more consecutive years.
The rationale for the criteria is easy to understand. Companies that pay regular—and rising—dividends send a powerful message about their financial health and stability. Maintaining a dividend forces discipline on managements that are prone waste shareholder wealth on nonsensical mergers and “empire building.” Dividends are also honest; there can be no cooking of the books or “creative accounting” when the accounts have to be settled in cash.
Given the similarity of the two ETFs, it is hard to see how PowerShares justifies its higher fee. If you like the Dividend Achievers strategy, go with VIG. You’ll pay almost two thirds less in fees.
As a sort of hybrid between the first high-yielding category and the second high-growth strategy, PowerShares also offers the High Yield Dividend Achievers ETF (NYSE: PEY). This fund is based on the Mergent Dividend Achievers 50 Index, which holds the 50 highest-yielding stocks of the broad Mergent dividend index, on which PFM is based.
Standard & Poor’s has its own competing strategy called the Dividend Aristocrats, which goes even further than the Dividend Achievers. The S&P 500 Dividend Aristocrats Index measures the performance of the companies within the S&P 500 that have increased their dividends every year for the last twenty five or more consecutive years.
In a similar methodology to PEY, the SPDR S&P Dividend ETF (NYSE: SDY) builds a portfolio out of the 50 highest-yielding Aristocrats.
While both PEY and SDY offer very attractive yields, their higher portfolio turnover would make them less attractive than DVY for taxable investors. You’re already being taxed twice on the dividends; why be taxed again with capital gains distributions?
This brings me to the third category: dividend-weighted ETFs.
WisdomTree is a relatively new entrant into the ETF sphere, but the company has carved out a distinct niche with its use of fundamental weighting rather than traditional market-cap weighting. The problem with traditional index funds is that they tend to overweight the companies and sectors that are faddishly overvalued due to the current whims of the market (think of tech stocks in the 1990s or financials in the 2000s). By weighting an index by a fundamental value—such as earnings or dividends—you largely eliminate this bias. This was WisdomTree’s rationale for its Large Cap Dividend (NYSE: DLN) and Total Dividend (NYSE: DTD) ETFs.
Because their weightings are based on the dollar size of the dividend rather than the yield, the WisdomTree funds will tend to be biased more towards mega caps than the other ETFs. This is not necessarily a bad thing, however. In fact, of all of the ETFs in Figure 2, I consider WisdomTree’s DLN to have the best potential for capital gains in the years ahead specifically because of its exposure to quality blue chips. The low fees and low turnover are also quite compelling.
Still, if it is yield that you are looking for in an investment, the WisdomTree ETFs might not be the best choice. The yields are considerably smaller than those of DVY, PEY, and SDY.
Which One is Best?
Let’s now return to our original question: how do we choose the right dividend ETF? The answer is that it really depends on what it is you are trying to accomplish. To keep it simple, I’ll break it down like this:
- For the best combination of high current income and tax and fee efficiency, go for DVY.
- For the best long-term growth prospects, VIG is your best bet. Though if your objective is growth, make sure that you reinvest your dividends. Compounding is the key.
- For the best medium-term (5-7) year allocation, DLN is probably your best option. Large-cap, high-quality companies represent some of the most attractive investments at current prices, and DLN is loaded with them.
With the economy still looking wobbly and many sectors of the stock market looking extended, stocks that pay consistent dividends have never looked more attractive. With this in mind, investors should consider adding a dividend-focused ETF to their portfolios.
Charles Lewis Sizemore, CFA
This article was first published on InvestorPlace
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