ETF Takes a New Look at Dividends

New fund incorporates forward earnings estimates in underlying index

The American Stock Exchange on Wednesday launched the first dividend-focused exchange-traded fund (ETF) that incorporates forward earnings estimates in its underlying index. The ETF carries an expense ratio of 0.45% and trades as the First Trust Morningstar Dividend Leaders Index Fund (FDY).

The underlying index assembles the top 100 dividend-paying stocks from the broad Morningstar U.S. Market Index representing 97% of domestic companies, said Sanjay Arya, director of Morningstar Indexes.

To create what the firm calls a "true high-yield portfolio," components are screened for their dividend payment history, in order to identify those with a consistent history whose dividend is higher than it was five years earlier, and for their 12-month consensus forward earnings estimates, to weed out companies whose dividend may not be sustainable.

Morningstar Managing Director Don Phillips describes the index as part of a trend toward designing indexes as investible products by incorporating forward earnings estimates. The index, which debuted in January, will be rebalanced quarterly and reconstituted annually.

Index providers such as Dow Jones, MSCI, and FTSE have incorporated forward earnings estimates in value and growth indexes over the last 10 years, and forward dividend estimates were used in a FTSE U.K. dividend index launched in late 2005. Morningstar is the first to do so in a U.S.-based dividend index, said Srikant Dash, index strategist at Standard & Poor's.

Individual stock holdings are capped at 10% of the portfolio, while holdings with more than 5% weighting may not exceed 50% in aggregate, in accordance with regulations. Although it doesn't specify sector allocation, the selection process is designed to broaden holdings, said Arya.

Unlike the six dividend ETFs already in existence, the new ETF's index is weighted according to "available dividends" -- defined as shares outstanding minus those closely held by insiders, times dividends per share. This structure prevents a small-cap bias from forming, as can occur in indexes weighted by dividend yield, Phillips explained.

Indexes that favor small-cap stocks may outperform in certain markets, Phillips added. But rather than produce marginal benefits, the firm intends the index as a core portfolio holding that will provide returns in both up and down markets.

With the number of dividend-focused ETFs growing and attracting assets, Standard & Poor's will continue to track them as well as clarify their characteristics and their role asset allocation.

First Trust Morningstar Dividend Leaders Index Fund (FDL)

Underlying Index: Morningstar Dividend Leaders Index
Index Constituents: The 100 highest-yielding stocks on the Morningstar U.S. Market Index, excluding REITs, that have consistent records of dividend payments and the ability to sustain future payments.
Weighting: Available dividends. (Stocks in index are weighted in proportion to the total pool of dividends available to investors, excluding insider-owned shares.) No individual holding can represent more than 10% of portfolio.
Net Assets: N/A
Expense Ratio: 0.45%

iShares Dow Jones Select Dividend Index Fund (DVY)

Underlying Index: Dow Jones Select Dividend Index
Index Constituents: The 100 highest dividend-yielding securities, excluding REITs, in the Dow Jones U.S. Total Market Index.
Weighting: Dividend yield
Net Assets: $6.41 billion
Expense Ratio: 0.40%

PowerShares Dividend Achievers Portfolio (PFM)

Underlying Index: Mergent Broad Dividend Achievers Index
Index Constituents: U.S. stocks that have increased annual dividends for the past 10 or more years.
Weighting: Modified market-cap weighting. No individual holding can represent more than 4%.
Net Assets: $23.5 million
Expense Ratio: 0.60%

PowerShares High Growth Rate Dividend Achievers Portfolio (PHJ)

Underlying Index: Mergent High Growth Rate Dividend Achievers Index
Index Constituents: 100 U.S. stocks that have raised annual dividends for the past 10 or more years and delivered the highest dividend growth rate.
Weighting: Modified market-cap weighting. No individual holding can represent more than 4%.
Net Assets: $25.7 million
Expense Ratio: 0.60%

PowerShares High Yield Equity Dividend Achievers Portfolio (PEY)

Underlying Index: Mergent Dividend Achievers 50 Index
Index Constituents: The 50 highest-yielding stocks of companies that have raised their annual dividend for 10 or more consecutive years.
Weighting: Dividend yield
Net Assets: $490.0 million
Expense Ratio: 0.50%

PowerShares International Dividend Achievers Portfolio (PID)

Underlying Index: International Dividend Achievers Index
Index Constituents: Foreign stocks that trade as ADRs and have increased annual dividends for the past five or more years.
Weighting: Dividend yield
Net Assets: $142.8 million
Expense Ratio: 0.60%

StreetTRACKS SPDR Dividend ETF (SDY)

Underlying Index: Standard & Poor's High Yield Dividend Aristocrats Index
Index Constituents: The 50 highest-yielding stocks in the S&P SuperComposite 1500 Index whose dividend has been increased annually for the past 25 years.
Weighting: Dividend yield. No holding can represent more than 4%.
Net Assets: $75.8 million
Expense Ratio: 0.3%
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