Advice Column: 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