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.