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Higher Yields, Hold the Risk

Do dividend ETFs live up to their name? Use this screen to put them to the test.

Bradley Kay, 06/03/2009

We have seen a proliferation of dividend ETFs in the past several years, offering the alluring promise of steady income from a low-risk stock investment. Unfortunately, as the markets collapsed at the end of last year, most of these income funds fell alongside them or even faster. Most of these funds had not found the magic stock screens that separate the high-yielding princes from the numerous distressed frogs. Investors saw their payments cut as companies slashed dividends, and they were left with no cushion against the precipitous fall in the fund price. But were there any dividend funds that succeeded where the others failed? For this screener, we decided to put them to the test along with the rest of the ETF universe and look for higher dividends that came with lower risk.

The first thing we need to do is make sure that we are screening for stock funds. Bonds may provide a steady yield and low risk, but they have a return to match. Even ignoring the potential for capital gains, stock yields tend to grow over time along with the companies who pay them. Bonds offer a higher income now, but it will never grow to keep up with inflation. Plus, most equity dividends qualify for special tax treatment at a lower rate, while bond interest payments contribute to taxable income. To this end, we used an initial screen to make sure that we only looked through ETFs of domestic or international stocks.

Special Criteria = ETFs
And ( % US Stocks>= 50
Or % Non-US Stocks >= 50 )

Now we need to check on those dividends. Numerous factors can affect the 12-month yield for an ETF other than its current income generation. Many funds in our database could have high 12-month yields from holding previously high-yielding stocks such as General Electric GE or Bank of America BAC, having large outflows between dividend payouts in the last year, or from recently changing their payout schedule. None of these explanations would imply strong income for shareholders in the future. So we instead look at the SEC yield, which is a measure of how much the fund has been paid in dividends or interest income over just the past 30 days. This gives a good idea of what sort of yields the portfolio is still receiving today, even after a major round of dividend cuts, without distortions from logistical factors such as fund flows or payout dates. Because the stocks in the S&P 500 yielded 3.31% at the end of March, we decided to use that as the minimum for our screen.

And SEC Yield >= 3.30

And of course we want to cut down on that risk. Modern finance theory says we should only pay attention to betas, or exposure to major risk factors in the market. But risk factors can be a slippery subject, as there are anywhere from one to five of them depending on whom you ask. And if you have a major stock holding to provide income, chances are that you don't care if it only goes down a lot when the market's doing well. We want a stable fund, so we will look at the total risk as measured by the standard deviation, or variation of the fund's returns over the past three years. This does cut out some of the most recent ETFs from our consideration, but at least six dividend-focused ETFs date back far enough for this screen to apply. For our maximum allowed risk, we once again choose to benchmark against the S&P 500, which has had a standard deviation a bit over 17.5% in the three years up to March 31, 2009.

And Std Dev 3 Yr <= 17.50

Still, standard deviation can miss some important risks. Really big one-off crashes affect cumulative returns more than they affect standard deviation calculations, and standard deviation punishes a fund for positive returns with a bit of volatility. What we really care about is how it performed when the market came crashing down. At the end of 2008, did we lose less than the market? So we apply one more simple risk screen and check that the return for 2008 was higher than the negative 37% drop experienced by the S&P 500.

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