From the July 2014 issue of Investment Advisor • Subscribe!

Not All Dividends and Dividend ETFs Are Alike

These products have nuanced risks that call for deep understanding

Some dividend products are better than others. Some dividend products are better than others.

Equity dividends have of course long played a crucial role in investing for many reasons, including providing income diversification away from credit and interest rate risks tied to traditional bond strategies, exhibiting an indicator of a company's stability as well as an important component in a stock's total return.

But not all dividends, distributions or other forms of payouts are the same. All yield-generating vehicles, individual issues and exchange-traded products have risks or vulnerabilities that must be understood. Adding dividend income from diverse sources is an outstanding risk management approach, especially with interest rates near all-time lows.

Some risks and vulnerabilities will remain apparent. Master limited partnerships (MLPs) and MLP ETFs can fluctuate from the volatility of the energy commodity space. For public equities, the highest yielding stocks tend to originate from the telecom and utilities sectors, and rising rates tend to hit these companies that are often viewed as bond proxies.

Clients can always benefit from a reminder that something yielding 8%, 9% or 10% in a 0% world will have relatively high risk, as the higher yield compensates for the increased risk. For example, mortgage REITs tend to have very high yields but are complex, highly leveraged vehicles that occasionally get hit very hard in the market. Last summer, the iShares Mortgage Real Estate Capped ETF (REM) fell approximately 26% over a three-month period when former Federal Reserve Chairman Ben Bernanke first mentioned reducing asset purchases.

A more nuanced downside to some dividend growth ETFs is that these products do not actually have a good track record for growing their dividends. These funds usually own stocks that meet some criteria such as having raised dividends every year for 20 or 25 years. When a company does not raise its dividend, or cuts its dividend as many financial companies did during the financial crisis, it is subsequently removed from the dividend growth ETF and replaced with something else that meets the criteria for inclusion.

If the removed stock is replaced with a lower yielding stock, it has the effect of reducing the dividend paid by the fund. Many dividend ETFs had heavy exposure to financial stocks and now have less, which has been a drag on the dividends these funds pay.

The other issue affecting not just dividend growth funds, but many other dividend ETFs as well as mutual funds, is the growth of the fund's share count through the creation of more shares. As a simplified example, if an ETF owns 10,000 shares of Pfizer (PFE) on Pfizer's ex-dividend date, it will receive the corresponding dividend on the stock's pay date and accrue that dividend to pay fund shareholders on its own pay date.

If the ETF in question doubles in size between receiving the Pfizer dividend and paying its dividend to fund shareholders, then it will obviously own 20,000 shares of the company but will only have received a dividend for 10,000 shares of Pfizer. Therefore, the ETF will be paying 10,000 shares worth of dividends to 20,000 shares of stock it holds. This scenario can work both ways if investors leave the ETF before the ex-dividend date, which would allow more income to the remaining shareholders.

Another option to consider is the ability to invest in a high-dividend equity strategy and hedge the equity principal exposure with a short ETF. There are important issues to keep in mind with this approach. First, understand that being long a high-dividend equity ETF also likely means being mostly long utilities and financial stocks as earlier mentioned. If a true short ETF is used, as opposed to an inverse fund, then it is likely that the short ETF will avoid such high-dividend-paying securities due to those equities’ costs of carry. The equities likely shorted are then in other sectors such as technology.

While not a perfect hedge, the intended purpose is to avoid a market decline. Historically when that happens, the correlation of the equities usually goes to one. It is essential to note that the anticipated yield might not be as high as desired with the hedge. For example, fully hedging a high-dividend equity position with a historic yield of 6% within a $100,000 portfolio requires allocating 50% into the long ETF and 50% into the short ETF, which would provide a net yield of approximately 3% across the portfolio. For some clients, that discount on yield may be reasonable enough to mitigate the equity market risk.

The notion that dividend-oriented individual issues or funds have risks and drawbacks does not invalidate them. Such funds are crucial components of a diversified portfolio. The multi-decade shift of 76 million baby boomers into retirement ensures demand for dividends. Clients will continue to ask about “new” ways to find yield, which will be further incumbent upon advisors to consistently understand the pros and cons of all strategies in the ETF space.

Page 1 of 2
Single page view Reprints Discuss this story
This is where the comments go.