ETFs Paying Dividends

It certainly has been a lousy time to be a dividend investor. Indeed, sectors that have historically been popular with dividend investors, such as financials and real estate investment trusts, have been some of the hardest hit groups over the last 18 months.

And plummeting stock prices are only part of the pain. More than 40 companies in the S&P 500 have cut their dividend payouts this year--a total reduction of roughly $41 billion a year in cash lost to shareholders. That amount is greater than the total dollars in lost dividends for all of 2008--a historically lousy year for dividends!

Moreover, things are not likely to get better anytime soon. Weak corporate profits and fragile balance sheets will continue to pinch dividends. And with so many companies cutting or omitting them, the stigma attached to a dividend cut has all but disappeared. Don't be surprised to see more companies trimming their payouts.

Yet, despite all the bad news surrounding dividends, one important point remains: Many of your clients don't just want dividends; they need them.

Every day in this country, more than 10,000 people turn 60. My guess is that these aging boomers represent your typical client. And increasingly, these clients are demanding two things from their investments: cash flow and safety.

One could argue that there has never been a better time to look for attractive, dividend-paying stocks. Massive stock declines over the last 12 months have boosted dividend yields to their highest levels in many years. The current yield on the S&P 500 Index as of March 31 was more than 3% versus the roughly 2.6% yield on 10-year Treasuries. You'd have to go back to 1958 for the last time stocks as a group had a higher yield than 10-year Treasuries!

Yield-starved clients have few options for generating needed cash flow. Many bond sectors have been almost as dicey as stocks. Like long-term Treasuries, most bank CDs offer paltry yields below 3%; and the yields on short-term Treasuries, money markets and brokerage sweep accounts are approaching zero. Your clients may have been willing to accept virtually no yield for fear of further declines in the stock market, but that sort of risk aversion is not sustainable. At some point, they will demand higher yields.

But if 2008 and 2009 have proved anything, it's that simply picking "marquee" stocks with decent yields is a potentially dangerous approach. Given the number of widely held stocks that have cut their dividends (can you say G-E?), chances are pretty good that your clients held one or several of them. And you don't want to go through that again.

In fact, from an advisor perspective, there's probably little upside for dividend-focused clients to own individual stocks, and plenty of grief should the companies cut their dividends. A better approach is to invest in a basket of dividend payers providing needed diversification while limiting the impact--not to mention client ire--of a dividend cut in one of the holdings.

Enter ETFs

As the table shows, there is no shortage of ETFs bearing attractive yields. But because lots of high-yielding ETFs held lots of financials, many of them were not exactly stellar performers over the past year. When financials got crushed, so did the ETFs, so understanding sector exposure is important in analyzing which ETF makes the most sense for your clients.

Another consideration is whether the ETF's yield provides a valid indication of the expected cash flows it will distribute to your clients. To that end, I purposely omitted from the table ETFs that invest in REITs. That may surprise some of you since REITs are typically a favored hunting ground for dividend-hungry investors. However, when it comes to dividends, REITs present a special problem this year. Admittedly, I'm not a fan of real estate investment trusts. I don't like the fact that REIT dividends usually don't receive the preferential 15% tax rate. And the dependency of REITs on the potentially volatile commercial and industrial real estate markets is a concern. But the troubling issues that have surfaced over the last 12 months go beyond weak price performance. In fact, in some respects, REIT cash dividends are becoming an endangered species.

According to data compiled by BMO Capital Markets, roughly 30% of all listed REITs negatively altered their dividend policies within the past year. And in a new twist on "sticking" it to shareholders, a growing number of REITs are paying part of their dividend in company stock.

Typically, REITs are required to pay 90% of pre-tax income to shareholders in cash. But an IRS ruling now gives REITs the flexibility to pay as much as 90% of the intended dividend in the form of stock and just 10% in cash for tax years ending on or before Dec. 31, 2009. And many REITs are taking advantage of the ruling by paying out most of their dividends in stock.

These stocks are really stock splits masquerading as dividends. Indeed, shareholders receive more shares, but their total ownership percentage doesn't change. No value is created and certainly, no cash flow is generated.

To make matters worse, under the IRS rule, shareholders will be taxed on all dividends received--including stock dividends--which is like paying taxes on a stock split!

Given that many REITs find themselves in a cash crunch, I suspect we will be seeing more of them cramming down these "stock-instead-of-cash" dividends to shareholders. That's bad news for ETFs that invest in REITs.

For starters, while these ETFs may generate little in the way of cash flow for your clients, they could generate big potential tax headaches as a result of the tax on those stock dividends. And the stated yield of the REIT ETF has the potential to be misleading because you'll have no idea how much of the dividend is paid in stock versus cash. So if you want an ETF that pays a good yield and throws off healthy cash flow for clients, I suggest avoiding ETFs that focus on REITs.

Also missing from the table are ETFs that focus on foreign stocks. In many cases, dividends on foreign stocks are paid only annually or semiannually and can be greatly affected by currency fluctuations. Thus, an 8% "yield" on an ETF that invests in foreign stocks may be less in terms of the cash flows that it throws off. That doesn't necessarily mean avoid foreign ETFs, but be aware that the stated yield is, at best, an approximation of the actual payout.

A Special Mention:

Among the sector ETFs, the following warrant special mention:

Vanguard Mega Cap 300 Value (MGV) tracks the performance of the value companies in the MSCI U.S. Large-Cap 300 Index. Yielding 4.4%, the portfolio has a median market capitalization of $51 billion. The fund holds more than 150 names, with financials representing roughly 16% of assets. Among financials, JPMorgan Chase is the largest holding at 3.4% of assets, followed by Wells Fargo at 2.0%.

Financial stocks represent about 25% of the iShares S&P MidCap 400 Value ETF (IJJ), down from 29% at the start of the year. Overall, the fund holds 285 stocks, and the three largest positions are financials. The fund ranks among the top 10% of its category for one- , three- , and five-year performance. Yielding 5.2%, it charges a modest 0.25% annual expense ratio.

iShares Russell 2000 Value (IWN) yields a nifty 4.6%, versus 3.4% for the broad Russell 2000 Index. The fund is home to nearly 1,300 stocks, with a portfolio tilted toward financials (36% of assets) and consumer discretionary stocks (13%). At the end of March, 11 of the 25 largest holdings were financials. The fund ranks among the top 1% of small-cap value funds for one-year total return.

Vanguard High Dividend Yield (VYM), which mimics the FTSE High Dividend Yield Index, has a yield of 5.0%. The underlying index consists of U.S. stocks that are ranked by annual dividend yield, but excludes REITs, as the securities do not pay qualified dividends. As of March, the fund held 503 stocks, with a median market cap of $33 billion. Financials accounted for 16% of the portfolio, with health care at 14%.

Chuck Carlson, CFA, (ccarlson@horizoninvestment.com) is CEO of Horizon Investment Services LLC and author of the book, Winning With The Dow's Losers. David Wright, CFA, provided research assistance on this article.

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