The Hidden Treasure of Dividend Investing

In one of the all-time best action thrillers, archeologist and adventurer Indiana Jones survives snake pits and highway bandits to win the prize, only to see it mothballed in a government warehouse. Many investors end up like Jones, taking plenty of risks without any big reward in return. By contrast, dividend investing is not known for its excitement, but its steady approach can smooth the risks and provide steady income.

Today, three key developments are driving interest in dividend investing: recent tax law changes, uncertain equity returns and a titanic demographic shift away from growth to income investing. Realizing the opportunity at hand, companies like Mergent and Dow Jones have developed dividend indices, each with its own rigorous methodology. “Dividend investing works for young and old investors alike as dividend paying companies typically generate higher total returns with less volatility,” says Shirley J. Petersen, vice president of index services at Mergent.

As investor demand for dividend-oriented financial products has risen, so has supply. Launched in the fall of 2003, the iShares Dow Jones Select Dividend Index Fund (DVY) set the tone; as a result of its head start, the fund has become one of the largest ETFs out there, with roughly $6 billion in assets. The fund tracks 114 holdings weighted according to dividend payout. Top sectors include bank stocks (over 35 percent of assets) and electricity companies (13.84 percent).

PowerShares has four dividend-oriented ETFs, all based on Mergent indices. The PowerShares Dividend Achievers (PFM), the broadest of the group, held 318 stocks during the first quarter. For those interested in high income, the PowerShares High Yield Equity (PEY) targets an index of 50 high-yielding companies with a track record of raising dividends for at least the last 10 years. At the end of May, PEY had a yield of 3.24 percent. On the global front, the PowerShares International Dividend Achievers (PID) tracks American Depository Receipts (ADRs) with a five-year track record of dividend hikes, most recently holding 60 stocks with a collective yield of 2.89 percent.

The First Trust Morningstar Dividend Leaders Index (FDL) screens stocks with five-year dividend growth and weights them in proportion to their “available” dividends, which Morningstar calculates by multiplying the dividend per share by the float. Individual stock weightings are capped at 10 percent and stocks weighing more than 5 percent cannot exceed 50 percent of the portfolio.

State Street’s SPDR Dividend (SDY) tracks the Standard & Poor’s High Yield Dividend Aristocrats index of the 50 highest-yielding stocks in the S&P 1500 with 25 years of rising dividends behind them. At the end of May, it had a yield of 2.54 percent and a low 30 basis-point expense ratio.

Not to be outdone, Vanguard launched the Dividend Appreciation VIPERs (VIG) in April. The fund uses the Mergent Dividend Achievers Select index, a subset of Mergent’s broadest dividend benchmark. It has 215 holdings with consumer staples, financials and industrials accounting for 60 percent of the sector weighting.

Newcomer WisdomTree Investments is also banking on dividend investing. In June, the company introduced a suite of 20 dividend-focused ETFs representing high-yield stocks from the Pacific Rim and Europe as well as domestic equities.

Tax Law

The Jobs and Growth Tax Relief Reconciliation Act of 2003 changed the way the IRS treats dividends. Previously, dividend income was taxed as ordinary income at the taxpayer’s highest marginal rate. Now, investors with qualifying dividend income in tax brackets above 15 percent are taxed at a maximum rate of 15 percent — or 5 percent for lower tax brackets. The 5 percent tax on dividends will be reduced to zero in 2008, while the 15 percent tax will remain unchanged. Unless Congress acts to extend it, the Tax Relief Act is set to expire in 2009.