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Find Succor in These Large Dividends

Use this screen to find high-yielding ETFs that will weather the crisis.

Bradley Kay and John Gabriel, 02/02/2009

Financial markets around the globe are fluctuating violently because of greed and fear-- with fear overshadowing occasional glimpses of optimism over the past few months. Amid the unprecedented levels of volatility we are experiencing in the market today, it's no surprise that many investors are clamoring for some sort of stability, or a financial "safety net," if you will. To that end, we decided to screen our ETF database in search of the highest-yielding funds. If we are facing a period during which investors should expect lower returns because of the deleveraging process that our financial system is undergoing and the looming threat of a global slowdown, then sustainable dividend payments could be an excellent way to ensure that we're capturing our fair share of the market's returns.

The first thing we are looking for is the yield itself. When asked about his outlook for expected returns on Berkshire Hathaway's stock portfolio, Warren Buffett promptly replied, "We would be very happy if we earned 10%, pretax." Co-chairman Charlie Munger added, "You can take what Warren said to the bank. We are very happy at making money at a rate in the future that's much less than the past ... and I suggest that you adopt the same attitude." Given that attitude among some of the most successful investors today, we would be happy to lock in nearly half that return straight away through dividends, so we start by screening for ETFs with 12-month yields of 4% or higher.

Security Type = ETF
And 12 Mo Yield > 4

Next, we want to make sure these large payouts keep coming in the future and, we hope, grow over time. The goal is to sidestep those ETFs that, on the surface, appear to offer some very handsome yields but could see dividend payments slashed in lieu of raising or preserving capital in an attempt to survive the ongoing credit crunch. As banks and REITs face the credit crunch, we expect the fat yields on most financial-services stocks to disappear. So, to ensure that our ETFs provide sustainable dividends, we screen out those that have a greater than 15% stake in financials.

And % Financial Services < 15

It also helps to see if the market believes that the dividends paid by the companies inside these ETFs will remain sustainable. Because announced company earnings at this point still only include business results during the strong economy up to the end of September, reported earnings should be near a peak for most companies. If the stock's price/earnings ratio has cratered, the market likely believes the company is distressed or will lose much of its former profitability in the future. Neither scenario bodes well for the future of those companies' dividends. With the S&P 500 trading around a P/E of 10, we consider that a portfolio P/E ratio of 7.5 (about half the long-run average) should be sufficient to ensure that we are not buying a dangerously distressed set of stocks.

And P/E Ratio > 7.5

With ETFs, liquidity remains another critical factor to consider. If an ETF is too small or trades too infrequently, it can be very difficult to buy or sell shares at their fair value. Thankfully, you do not need to limit yourself to the largest funds in order to find sufficient liquidity for trades of thousands or tens of thousands of dollars. We generally find that ETFs develop sufficient liquidity for the individual investor after they reach assets under management of $50 million or more.

And Net Assets $ MM > 50

Finally, we want to look for ETFs with low fees that will not eat up all that yield. No single fee cut-off will work for this broad set of funds because sector-specific and international funds will often cost more than broad-based domestic ETFs. However, as virtually all of these funds track indexes, the main way that ETFs achieve 4-star performance against their mutual fund peer group is through low fees that allow investors to capture more of the portfolio's return. So as a proxy for low fees, we will search for ETFs with Morningstar Ratings of 4 stars or higher.

And Morningstar Rating >= 4 stars

As of Dec. 5, 2008, this screen produced five options from our ETF universe. In addition to the usual suspects in the utilities sector, this screen also highlighted beaten-down telecoms with their strong cash fl ows as a source of reliable yields. Top-quality multinationals with their unbeatable brands and solid balance sheets also provide a promising area to find sustainable dividends. Here are four recommended ETFs uncovered by our screen.

iShares S&P Global Telecommunications IXP
Although it has a portfolio of about 44 stocks, iShares S&P Global Telecommunications is very top-heavy thanks to its market-cap-weighted structure. In fact, the fund's top 10 holdings soak up approximately 70% of total assets. We're not deterred by the fund's heavy concentration, however, as its top holdings represent some of the global industry's top-tier franchises that boast diverse product portfolios and geographic exposure. At the end of the day, we think demand for phone, television, and Internet connectivity will continue to expand. The worldwide exposure afforded by the fund is another big positive, as investors can partake in emerging markets' rapid adoption of telecom services without assuming single-stock or single-country risk. In our view, some of the best-in-class telecom firms are trading at compelling valuations (already pricing in dire forecasts), offer above-average dividend yields, and have the capital and cash-generating ability to meet their near-term obligations and maintain dividend payments.PAGEBREAK

Vanguard Telecom Services ETF VOX
Although this ETF only covers U.S. telecommunications companies, it also charges a slim 0.23% expense ratio that is less than half the cost of its global rival from iShares. This ETF tracks the MSCIU.S. Investable Telecommunications Services Index, an all-cap market-weighted index that holds fewer than 50 stocks from U.S. companies offering communications services through fixed-line, cellular, wireless, high-bandwidth, or fiber-optic cable networks. The index is so concentrated that the ETF has to modify the weightings of its largest holdings to comply with IRS diversification rules, with AT&T T and Verizon VZ comprising more than 40% of the portfolio.

Utilities Select Sector SPDR XLU
This market-weighted ETF owns the utilities stocks in the S&P 500, giving it a large-cap portfolio. The top-heavy portfolio has nearly 60% of assets invested in the top 10 names, but these include diverse utilities providing companies providing water, electric, and natural-gas service. Because of the government protection of the utilities sector and utilities' strong pricing power within their natural monopolies, we have little concern that this ETF will not maintain its healthy 4% yield.

iShares S&P Global 100 Index IOO
This ETF offers one-stop shopping for a passel of well-known multinationals. The S&P Global 100 represents roughly 100 multinational companies with a minimum market capitalization of $5 billion, and it defines multinational firms as those with production facilities and other fixed assets in at least one nation besides its home country pursuant to a global strategy. In addition to the market-cap minimum, each constituent must meet certain liquidity and financial viability requirements. S&P then adjusts the portfolio to mirror the sector weightings of the S&P Global 1200 Index. The resulting portfolio parks more than 90% of assets in giant-cap stocks, with most hailing from the United States, United Kingdom, and France. The unbeatable quality of the companies that this fund holds, along with its wide sector and stock diversification, ensures that its already-excellent 5% yield will probably only grow in the years to come.

Bradley Kay and John Gabriel are ETF analysts with Morningstar.

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