Choosing The Right Dividend ETF
Well, it happened
— again. The 10-year Treasury fell all the way to 2.4% again on a string of bad
geopolitical news and mixed economic data. The last time yields were this low
was June of last year, in the early stages of the “Taper Tantrum.”
Could yields continue
to go lower? Sure, they could. But it
doesn’t matter. If you are an income investor with more than a five year
horizon, you should be looking outside of the bond market for your income needs
given the pitifully low yields on offer. And one area that still looks
attractive at today’s prices is the world of dividend ETFs.
Company dividends
— unlike bond interest — generally rise over time, giving dividend stocks far
better long-term inflation protection than bonds.
Not all dividend
stocks are the same; some are slow-growth dinosaurs that are little better than
bonds with respect to their sensitivity to rising interest rates. Others are
high-growth dynamos that share their bounty with their investors by continually
raising their dividend. And in the same way, not all dividend ETFs are the
same. Some are concentrated in slower-growth companies and sectors, while
others are a who’s who list of quality growth stocks.
I don’t like
choosing between growth and income; I want both. And today, I’m going to share
some of my favorite dividend ETFs that I expect to deliver the two.
Any discussion of
dividend ETFs should start with the granddaddy of them all, the iShares
Select Dividend ETF (DVY).
DVY’s underlying
index takes the universe of dividend-paying stocks with a positive
dividend-per-share growth rate, a payout ratio of 60 percent or less, and at
least a five year track record of dividend payment and then selects the 100
highest-yielding stocks. The result is an ETF loaded with high-yielding,
reliable dividend payers.
Not surprisingly,
DVY is heavily weighted in utilities and defensive consumer staples, currently
34 percent and 16 percent of the portfolio, respectively. The current
dividend yield is 3.1%—significantly higher than what the 10-year Treasury
pays.
As it is
currently constructed, DVY is not likely to outperform the S&P 500 in a
normal, rising market. It should, however, hold up far better during a
market rout—though this was not the case during the last bear market. DVY took
a beating in 2008 because it had a high allocation to the financial sector at
the time.
DVY is fine for
current income. But if it is growth you seek, try shares of
the Vanguard Dividend Appreciation ETF (VIG)—a long-time favorite of
mine. At 2.0 percent, VIG’s yield is not significantly higher than the
S&P 500. But you don’t buy VIG for its dividend today; you buy it for
its dividend tomorrow
VIG is based on
the Dividend Achievers Select Index, which requires its constituents to have at
least 10 consecutive years of rising dividends.
The rationale is easy enough to understand. There is no signal more
powerful than that of a rising dividend. Company boards hate parting with their cash; it’s a natural human
instinct to stockpile it—just in case. A willingness to part with the
cash is a signal that management sees a lot more of it coming.
Paying a dividend
requires discipline, as it means less cash to waste on value-destroying empire
building. And a rising dividend also shows that management knows its
place. They work for you, the
shareholder, and increasing your dividend every year is a way of showing that
they have their priorities straight.
By definition,
any stock currently in the portfolio continued to raise its dividend even
during the crisis years of 2008 and 2009. These are companies that can
survive Armageddon because, frankly, they already have.
There are
drawbacks to VIG’s 10-year screening criteria. A more recent
dividend-raising powerhouse like Apple AAPL +0.73% lacks the
history to be included in the Vanguard ETF. Also, as with any investment
strategy that depends on historical data, there is no guarantee that a ten-year
streak of raising dividends in the past will mean another good ten years of
increased payouts going forward.
Still, if you’re
looking for a portfolio high-quality stocks with a long history of rewarding
shareholders, then VIG’s dividend growth methodology is a fine plan place to
start.
VIG is not the
only ETF to focus on dividend growth, of course. PowerShares runs two
competing products. The PowerShares Dividend Achievers ETF (PFM) is
based on the same underlying index as VIG, though its fees are higher—0.55% vs.
0.10%. It’s hard to justify losing almost half a percent a year in
additional fees for what is substantially the same investment product.
The
PowerShares High Yield Equity Dividend Achievers ETF (PEY) offers a
smaller, higher-yielding slice of the dividend achievers universe, taking only
the 50 highest-yielding stocks from the dividend achievers screen. Though
also more expensive than VIG with an expense ratio of 0.55%, it pays a higher
yield at 3.4%.
And
finally, Standard & Poor’s has its own competing dividend growth strategy
called the Dividend Aristocrats, which goes even further than the Dividend
Achievers. The S&P 500 Dividend Aristocrats Index measures the performance
of the companies within the S&P 500 that have increased their dividends
every year for the last twenty five or
more consecutive years.
The SPDR
S&P Dividend ETF (SDY) is an ETF that builds a portfolio out of
the 50 highest-yielding Aristocrats.
So, if I
love the 10-year Achiever screen, I should really love the 25-year Aristocrat
screen, right?
Well, in
principal, yes. Though in practice, I find it to be a little too
restricting. Limiting your pool of stocks to companies that have raised
their dividend for 25 consecutive years leaves you with a portfolio of older,
slower-growing stocks.
Don’t get
me wrong; there are some real gems in SDY’s portfolio, including long-time
favorites of mine National Retail Properties, Target TGT -0.09% and Procter
& Gamble PG +0.22%. But overall, in
SDY, you are left with a defensive portfolio that I would expect to lag during
a normal bull market.
DIVI is
managed by Thomas Howard, a former academic turned money manager superstar and
the author of Behavioral Portfolio Management. It is also very different from all other
dividend ETFs I follow. Virtually uniquely among dividend ETFs, DIVI
includes equity REITs, mortgage REITs, master limited partnerships (MLPs),
closed-end funds and business development companies (BDCs) in its investment
universe, giving it a vastly different portfolio composition than its
competitors.
Also
uniquely among dividend ETF, DIVI employs a guru-following strategy that makes it similar in
principle to Global X Top Guru Holdings Index ETF (GURU) and
the AlphaClone Alternative Alpha ETF (ALFA), but with a more
active management style. DIVI uses Howard’s behavioral research to identify the
“high conviction” picks of active mutual fund managers, then selects
high-dividend payers from the screen. DIVI then diversifies across sector,
strategy and country to reduce risk.
DIVI is a
little on the expensive side for a dividend ETF with a net expense ratio of
0.99%. But given that DIVI is essentially an actively-managed mutual fund
in an ETF wrapper, the expenses are not disproportionate.
Of
course, no discussion of a dividend ETF is complete without a mention of the
dividend yield. DIVI has been trading for less than a month and thus has
no historical dividend yield. Based on the average yield of its top
holdings, minus manager fees and expenses, I believe that it will
generate in excess of 5% per year in dividends and perhaps more.
Charles
Lewis Sizemore, CFA, is the editor of Macro
Trend Investor and chief investment
officer of the investment firm Sizemore Capital Management. Click here to receive his FREE weekly
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