The WSJ reviewed the pros and cons of dividend ETFs in “Dividend ETFs Beckon Income-Starved Investors.” Let’s listen in:
Exchange-traded funds that focus on dividend-paying stocks trailed the market by a wide margin in 2009, but they may attract yield-starved bond investors who are also worried about the prospect of rising interest rates.
Several factors are causing some fixed-income investors to take a second look at stocks to generate income. Yields on CDs, money markets and high-quality bond funds are at paltry levels thanks to the Federal Reserve’s commitment to keep rates low to fight the recession.
Meanwhile, investors are anxious about potential losses in bond funds if interest rates rise. Bond prices and yields move in opposite directions.
There are dozens of dividend ETFs—the largest is iShares Dow Jones Select Dividend Index Fund (trading symbol DVY), with nearly $4 billion in assets. Other big ETFs in the category include Vanguard Dividend Appreciation ETF (VIG), SPDR S&P; Dividend ETF (SDY) and WisdomTree LargeCap Dividend Fund (DLN). (Dow Jones, a unit of News Corp., publishes The Wall Street Journal.)
Many companies were forced to scale back or abandon dividends during the financial meltdown to conserve capital, but the trend may be turning.
Last year, S&P; 500 companies paid out $196 billion in cash dividends, a “massive” $52 billion decline from the $248 billon paid in 2008, according to Standard & Poor’s Index Services.
Dividends have accounted for more than one-third of total U.S. equity returns since 1926, according to S&P.;
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Investors need to do their homework when choosing among dividend-themed ETFs, experts warn.
Because they invest in stocks, the funds have an “entirely different level of risk” than bond portfolios, said Bradley Kay, analyst at investment researcher Morningstar Inc.
Some are calling for a stock pullback now that the rally has pushed the S&P; 500 Index up about 70% from the March 2009 market low. Also, stocks with high dividend yields can be the riskiest and most-distressed companies within a particular industry, Mr. Kay said in an interview.
The iShares Dow Jones Select Dividend fund gained 11.2% in 2009 but trailed the S&P; 500 by 15.5 percentage points, according to Morningstar. Additionally, many dividend ETFs fell hard during the credit crunch as a result of their outsize exposure to the financial sector.
“There is no free lunch in the market, so the largest dividend yields tend to come from stocks that have fallen substantially, showing that investors do not believe the payments can be maintained,” Mr. Kay wrote in a recent report.
Whether some of these high dividends come from companies that have fallen or whether their stocks will eventually pull back sharply, does not really matter. In the aftermath of the burst credit bubble, with many long-term effects still being an unknown, the only way to guard against severe losses is to treat dividend ETFs just like you would any other investment in terms of having an exit strategy.
I discussed this necessity for bond funds, and dividend ETFs are no exception. If you are of the opinion that the bear of 2008 has been successfully conquered, then you can simply hang on to your investments. If, on the other hand, you believe like I do, that more moves in out of recessions are on the horizon over the next 10 years, then you must protect yourself against these types of cycles.
In my view, market volatility is here to stay. It’s questionable whether, after the next downturn, we’ll be so lucky to see a repeat rebound of the strength we’ve witnessed last year. Let’s not forget much of it was stimulus induced and supported by zero interest rate policy, a theme that can’t simply go on forever.
I prefer playing it safe by tracking trends and using sell stops. Why gamble and take a chance?
Disclosure: We currently have no holdings in the ETFs featured above.