I like ETFs as an investment vehicle.  And I love dividends as a source of investment return.

So, one might draw the conclusion that I was favorably disposed towards dividend ETFs, and indeed I am (see “Dividend ETFs for Growth and Income”).

Today, I’m going to take a look at one relatively new entrant in what has become a bit of a crowded fields: the iShares High Dividend Equity Fund ($HDV), which tracks the Morningstar Dividend Yield Focus Index.

To meet Morningstar’s criteria for index membership, companies must have a Morningstar Economic Moat rating of narrow or wide and have a Morningstar Distance to Default score in the top 50% of eligible dividend-paying companies.  The index is then composed of the top 75 companies by dividend yield that meet these criteria.

This requires a little explaining.  Warren Buffett has spoken often of preferring companies with economic “moats” around them that make a challenge from a would-be competitor a challenge.  Coca-Cola’s ($KO) unmistakable brand would be a good example, as would Microsoft’s ($MSFT) domination of the personal computer platform through its Windows operating system and Office productivity software. Not even mighty Apple ($AAPL) has been able to scale Microsoft’s moats in its core areas of expertise.

Morningstar has built upon this “moat” concept, defining it as “the sustainability of a company’s future economic profits.”  In order to earn a narrow or wide moat rating, a company must have “the prospect of earning above average returns on capital, and some competitive edge that prevents these returns from quickly eroding.” Obviously, there is a degree of subjectivity involved, as this is not a numeric value that can be found in a stock screener.  And to be sure, not all moats prove to be unassailable (consider that Research in Motion’s ($RIMM) enterprise email and messaging ecosystem might have been considered a moat just a few years ago). 

Morningstar’s Distance to Default Score is more quantitative yet also a little more esoteric.  It uses option pricing theory to evaluate the risk of a company becoming insolvent. 

While I like Morningstar’s focus on moats, I’m a little more skeptical on its distance to default metric.  Yes, the metric would probably do a decent job most of the time of preventing you from buying a high-yielding stock that was on the verge of slashing its dividend en route to going bust.  Yet option pricing theory would have done little to foresee an event like the 2008 meltdown until it was far too late, and it certainly didn’t prevent Long-Term Capital Management from blowing up a decade before.

HDV is a sibling to the older and better-known iShares Dow Jones Select Dividend ETF ($DVY), which I highlighted in the article I referenced above and which I use in my Covestor Strategic Growth Allocation.  DVY is the granddaddy of all dividend ETFs, and tends to be heavily weighted towards utilities (currently 31% of the ETF) and consumer staples (16%).

HDV holds a much smaller allocation to utilities (just 14%), but has large allocations to health care (29%) and consumer staples (24%).

According to iShares, both ETFs currently yield 3.6%, and both have expense ratios of 0.4%.  Over time, I would expect DVY to sport a higher current yield, though I would expect HDV to offer better potential for capital gains.  In the short-to-medium term, the decision of one over the other is essentially a matter of sector preference.

For longer-term capital gains, my preference remains the Vanguard Dividend Appreciation ETF ($VIG).  Though it currently yields no more than the broader S&P 500, the ETF is comprised of companies that have raised their dividends every year for the past 10 years.  And while there is no guarantee that they will continue to raise their dividends going forward, the 10-year criteria ensures that you own a portfolio of some of the highest-quality growth companies in the world.  The dividend criteria is also more objective than Morningstar’s moat rating, which depends on the judgment of Morningstar’s analysts.

With that said, any of the ETFs mentioned in this article could be considered as long-term holdings for investor portfolios.  But investors willing to do a little research on their own should eschew buying the ETFs and should instead use their holdings as a convenient stock screener.  Pick and choose the companies you like best from each.  Coca-Cola—which happens to be one of Warren Buffett’s all-time favorites—happens to be a holding of all three ETFs.

Disclosures: DVY, MSFT and VIG are held by Sizemore Capital clients. This article first appeared on MarketWatch.

If you liked this article, consider getting Sizemore Insights via E-mail. 

5 Responses