Using Dividend ETFs for Stability and Income

Dividends are a subject of endless fascination for investors, and no less so in the recent stock market environment of jaw-dropping volatility. With bond yields hovering near record lows and a growing number of baby boomers facing retirement, the role of dividends for investors appears likely to grow further in the years ahead.

Dividend-paying stocks hold particular attraction during periods of high market volatility, says S&P's Chief Investment Strategist Sam Stovall, because they tend to be larger, established companies with a history of profitability. "When the seas get rough, people prefer a larger ship, and that's why they tend to gravitate to larger cap stocks, which in turn tend to offer better dividend yields." They also appeal to those who want current income while preserving the potential for future gains, he says.

Dividends do carry risks, however, since they can be cut without warning, and during the recession of 2008 and 2009, many companies did just that. The good news, however, is that more companies are starting to make or raise dividend payments to investors, and more importantly, fewer companies are cutting or halting their dividend payments. In the first half of 2010, companies increased their annual dividend rates to the tune of $7.9 billion, according to Howard Silverblatt, senior index analyst at Standard & Poor's Indices, compared with $4.9 billion in reductions announced in the first half of 2009.

There are about 40 different ETFs specifically focused on dividend stocks, both domestic and international, and they employ a wide range of investment strategies. They vary in size from about $4 billion to just $8 million, and their annual fees range from 0.2% to 0.8%.

No sponsor is more prolific when it comes to dividend ETFs than WisdomTree, which operates about 20 dividend or equity income funds including numerous international, regional, or country funds. These ETFs track "dividend weighted" indices, in which the components are weighted according to the proportionate share of dividends paid among a certain group of companies. Claymore, First Trust, iShares, PowerShares, State Street, and Vanguard also offer ETFs employing various dividend-focused strategies: some ETFs buy stocks that not only pay but raise their dividends, others use proprietary methods to identify an optimal blend of shares in the highest yielding companies, and at least one uses a "dividend rotation" strategy that buys shares of companies about to pay dividends and then sells them.

A half-dozen or so dividend ETFs have an "Overweight" recommendation from S&P Equity Research, which ranks ETFs according to performance, cost, and risk factors. The largest of these, with almost $4 billion in assets at the end of May 2010, is the Vanguard Dividend Appreciation ETF, which takes as its mission the purchase of shares in "companies that have a record of increasing dividends over time." The ETF has 142 holdings, with about 40% of its assets concentrated in the ten largest. About one quarter of the fund is invested in consumer staple stocks such as Pepsico, Proctor and Gamble, and McDonald's. The ETF's SEC 30-day yield of 2.31% as of July 13, 2010 is only slightly higher than the S&P 500 yield of about 2.1%. S&P's recommendation is mostly based on the ETF's ultra-low costs and the high score of its holdings in S&P's Quality Rank--a measure of a company's long term growth and the stability of its earnings and dividends.

The Vanguard High Dividend Yield ETF is smaller, with about $840 million in assets, and an SEC 30-day yield of 2.95%. It is more diverse, with more than 500 holdings, and less focused on consumer staples, which at 17.6% as of the end of May is still its largest sector exposure. Like the Dividend Appreciation fund, S&P's recommendation is mostly based on its low cost and high Quality Rank.

The PowerShares Dividend Achievers Portfolio also earns an "Overweight" recommendation based on the Quality Rank of its holdings and the expected future performance of its holdings. It owns a diversified portfolio of stocks that increased their annual dividend in each of the last 10 years. It had about $150 million in assets and an SEC yield of 2.67% as of July 13. It has 212 holdings and an even larger exposure to consumer staple stocks, at about 27% of its assets.

A somewhat different approach can be found in the WisdomTree Dividend ex-Financials Fund, which earns a mention for its above-average SEC yield of 3.88% as of July 13th, and its lack of the same mega-cap stocks found in most other dividend ETFs. While it had about 16% of its assets in consumer staples stocks as of July 13, it has a slightly larger allocation to utilities, several of which are a top 10 holding. It holds 82 different names, making it more concentrated than other dividend ETFs, and it employs the dividend weighting method.

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S&P Senior Financial Writer Vaughan Scully can be reached at Vaughan_scully@standardandpoors.com. Send him your ideas for ETF story topics.

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