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Avoiding the Dividend Trap

When picking high-yield or dividend-themed funds, it's important to focus on quality.

Michael Rawson, 08/06/2010

Dividend-paying stocks are often seen as being higher-quality and more stable than their non-dividend-paying stock counterparts. Thus, they can be viewed as the next step up on the risk/return spectrum from lower-risk bonds to higher-risk stocks. But there is a point at which dividend-paying stocks actually become more risky than the average stock. Earlier this summer, shares of BP BP offered a trailing 12-month dividend yield of 9%. But the market was correctly forecasting that this dividend would be cut. Another example is New Century Financial, a subprime mortgage REIT that offered a dividend yield of around 18% at the peak of the housing bubble. That dividend did not last long, as the firm filed for bankruptcy when the bubble burst. In this article, we take a look at the ways that dividend-focused exchange-traded funds look to avoid this siren song.

Dividends have historically accounted for 40% of the returns from investing in stocks, and despite conventional wisdom, high-dividend-payout companies tend to have stronger earnings growth. So, the case for investing in companies that pay dividends is a strong one. It would seem that a logical way to achieve a high yield on a dividend fund would be to weight stocks by their dividend yield, so that high-yielding stocks would make up a larger percentage of the fund. But unfortunately, it is not correct that if dividends are good, a higher dividend yield must be better. The fact is that neither of these approaches would do anything to screen out the low-quality, risky companies that are likely to cut their dividends, or even file for bankruptcy.

Consistent Dividend Increases
One approach to overcome the challenge of the dividend trap is to select companies that have shown a consistent pattern of increasing dividends. Vanguard Dividend Appreciation ETF VIG and PowerShares Dividend Achievers PFM select stocks from a list of companies that have increased dividends for 10 or more years. SPDR S&P Dividend SDY kicks this up a notch by requiring at least 25 years of dividend increases. However, this results in just 50 holdings, which is perhaps too concentrated to serve as a core equity holding.

While PowerShares HighYield Dividend Achievers PEY requires 10 years of dividend growth, it is similar to SDY in that it uses a dividend yield weighting methodology rather than the modified market-cap-weighting approach followed by VIG and PFM. This results in a higher yield but also a higher volatility, as the highest-yielding stocks tend to be riskier. Because of their focus on high-quality stocks and their use of market-cap weighting, both VIG and PFM have a higher percentage of assets (about 60% each) invested in stocks with wide economic moats. In contrast, SDY has 23% and PEY has just 9% of assets in wide-moat stocks. Morningstar analysts define economic moat as sustainable competitive advantage.

It is no surprise that these funds tend to be overweight in consumer staples stocks and hold stocks with strong brand recognition. All three of these funds hold Coca-Cola KO, PepsiCo PEP, and McDonald's MCD. Firms with strong brands that are able to generate steady, repeat business are more likely to grow their dividends over time.PAGEBREAK

Weighting by Dividends Paid
A second approach to avoiding the dividend trap is to weight stocks based on the total dollar amount of dividends paid rather than by dividend yield. This results in a tilt toward larger-cap companies, as they tend to be the ones that pay out the largest dividends on an absolute basis rather than on a percentage basis. WisdomTree LargeCap Dividend DLN follows this approach; its two largest holdings are AT&T T and ExxonMobil XOM. Also, iShares Dow Jones Select Dividend Index DVY weights by dividends but uses some additional screening criteria, such as requiring five years of dividend growth and an average dividend payout ratio of less than 60%, for inclusion in the index.

Diversification
Vanguard High Dividend Yield Index ETF VYM uses a diversification and market-cap-weighting approach to minimize the impact of a few low-quality stocks on the portfolio. The fund ranks stocks by dividend yield then includes all stocks until it accumulates 50% of the market cap of the broader universe. Weighting by market cap means that the more stable, larger names dominate the list, but it also includes hundreds of smaller-cap stocks that pay high dividends. All-in, YYM holds 563 stocks. The comprehensive WisdomTree Total Dividend DTD weights stocks that trade on U.S. exchanges and meet certain liquidity requirements by dividends, resulting in a whopping 757 holdings.

Other Methods
First Trust Value Line Dividend Index FVD picks stocks with a higher than average dividend yield, but it requires that they be ranked in the top two out of five safety rankings, which are based on stock price stability and balance-sheet quality. The fund then equal weights these stocks.

For comparison purposes, we have included the S&P 500 Index in the table, as well as two bond ETFs: iShares iBoxx $ Investment Grade Corporate Bond LQD and iShares iBoxx $ High Yield Corporate Bond HYG. Unfortunately, many of the dividend-focused ETFs were overweight financial stocks heading into the 2008 crisis, and this hurt their performance relative to the S&P 500 over the past three years. Both bond funds had much stronger performance and the lower risk that you would expect from being higher up in the capital structure. But going forward, they offer less potential for capital appreciation. Furthermore, as the name implies, fixed-income securities pay a "fixed" dividend, while stock dividends have the potential for growth. Remember, all of the upside beyond the fixed-income contractual obligations accrue to stockholders.

Conclusion
For income investors who want to invest only a small portion of assets into just the highest-quality stocks, we recommend Vanguard Dividend Appreciation ETF. Not only has this fund had a better than average return over the past three years, it has also had the lowest volatility of the nine funds mentioned in this article. On the flip side, for investors who want an even higher yield and are willing to accept the higher risk inherent in that strategy, we'd recommend a closer look at SPDR S&P Dividend.

Michael Rawson is an ETF analyst with Morningstar.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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