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By Paul Justice, CFA | 03-30-2011 04:47 PM

Picking the Right Dividend ETF

Morningstar ETF analyst Mike Rawson surveys the pros and cons of the different strategies employed by dividend ETFs.

Paul Justice: In a low-yield environment, the allure of a high dividend can be all the more tempting.

I am Paul Justice, director of North American ETF research at Morningstar. Today, we are here to talk about dividend-paying ETFs, and I am joined by Mike Rawson, our ETF analyst who's covering broad indexes and dividend-paying funds. Mike, thanks for joining me.

Michael Rawson: Thanks for having me, Paul.

Justice: So, Mike, we've had a lot of focus on dividend-paying ETFs these days. Could you talk about the reason why you might want to pick out a dividend-paying ETF and maybe some of the things you might want to look at besides that dividend yield?

Rawson: Absolutely. When we think of dividend-paying stocks, we often think of them as being safe investments because they are going to give you that constant stream of income through the dividend. However, we need to be careful that when we look at individual stocks, sometimes the higher the dividend yield, the riskier the stock can be. It can kind of be an indication that maybe investors are thinking that the firm may have to cut its dividend. So, that's where the benefits of the diversification you get from investing in a fund really come into play.

However, there are a couple of things you might to look at before you go about selecting a fund. For example, there are two main approaches that funds use to try to reduce that risk. One is, how they select the individual stocks that go into the fund, and the other approach is how they weight those stocks.

Justice: So, they are going to look beyond just that dividend yield. They are actually going to take some measures to make sure that they are mitigating the risk, potentially--hopefully.

Rawson: Absolutely. So, one approach a fund might use is to screen out stocks based on how they've paid out dividends in the past. So, the iShares DVY--the iShares Dow Jones Select Dividend Index Fund.

Justice: A really popular fund...

Rawson: It is really popular.

What it does is it looks for stocks that not have not decreased their dividend in the past five years, actually maintained it or perhaps increased it over the last five years, but it's looking for the highest-yielding stocks. And then not only does it take the highest-yielding subset, it also weights the stocks in the portfolio by the yield. That those definitely get the yield of the overall fund up, but it also tends to increase the risk. So you are going to have more volatility, more standard deviation in your returns, and in fact, right before the financial crisis, this is one of the funds that was overweight in financials, which as we all know, suffered. So, this fund over the past several years has lagged the S&P 500 because of the financial crisis.

Justice: Now, have they adjusted this fund at all since that crisis?

Rawson: Certainly it rebalances annually, and as we know, Dow Jones has a little bit more of a committee type of approach, where they'll review the stocks that are in their fund. But usually even a committee is not able to predict what's going to happen in the market. So, your best bet is to try to go with a good structure.

One of the structures we kind of prefer is an approach used by the SPDR S&P Dividend ETF; the symbol there is SDY. What it does is, instead of taking just five years, which is what DVY does, SDY takes 25 years and says, "I want a company that's grown its dividends consistently for 25 years." Now, it still weights by yield, so you are still going to get a pretty high yield for your fund overall, but any firm that's been able to increase its dividend for 25 years has made it through several cycles, so this fund has actually been a little bit more stable. We prefer it.

Another approach that funds use instead of weighting by yield--which again gets the yield up, but also gets the risk up--instead of weighting by yields, some funds weight by the actual amount of the dividends the companies pay. So for example…

Justice: So, the dollar value?

Rawson: ...the dollar values, exactly. The largest funds are able to payout the biggest dollar value of dividends. So WisdomTree's LargeCap Dividend DLN weights firms by the amount of dividends paid out, so again, it's going to skew toward those larger firms, but it's going to give you a decent dividend yield. It's not going to be as risky as a yield-weighting approach.

Justice: But it did run into the financial crisis in 2008?

Rawson: It did, but it actually held up a little bit better than DVY did.

Justice: Okay.

Rawson: And perhaps one of our favorite dividend funds is actually really not much of a dividend fund at all. It's actually more of a quality fund. It's just using dividends to help it select quality stocks. What this fund does is it looks for 10 years of dividend increases. So, not as long as the 25 years, but still a long amount of time for dividend increases, and it weights the funds in the stock by market cap. So, it's definitely a large cap.

Justice: And which fund is this?

Rawson: This is Vanguard Dividend Appreciation.

Justice: So, a Morningstar favorite, and we've definitely talked about this fund often; a 5-star fund and a holding in our portfolios and the ETFInvestor newsletter.

Rawson: Absolutely. Now, the dividend's going to be a little bit lower here. In fact, it's going to be just about the same as the S&P 500, but what you are really doing is you are looking for quality companies. One of the measures Morningstar uses for quality is the economic moat, and of all the funds we cover, this fund has one of the highest percent of its assets invested in wide-moat stocks. Companies like ExxonMobil, Coca-Cola, and McDonald's, companies with strong brand names that are able to sustain and grow their dividends over time.

Justice: Which is a very important factor. Any dividend investor who has experience knows that you are not only focused on today's yield, but what tomorrow's yield is going to be based off your cost basis. So, hopefully, you can get that capital appreciation and a nice income stream in the future.

Rawson: Absolutely.

Justice: In a challenging yield environment, that income is pretty hard to come by, and for you to settle on a fund with a lower yield today may seem counterintuitive, but it may pay off down the road.

Rawson: Absolutely. If anything, you want to be cautious of looking at today's yield because that's just a projection based on what they paid in the past, and if the market is discounting what it may pay in the future, that yield may look more attractive today just because people are not as willing to pay as high of a price, the price of the stock falls, and it forces that trailing yield to look more attractive. So, you definitely want to be careful when looking at just the average yield of a fund. You want to dig a little bit deeper.

Justice: Now, one consideration we've gotten from subscribers, and we've seen in the data is that, sometimes the dividend from an ETF can fluctuate more often than what you will see, say, in other fund structures. Could you just dive into that a little bit it and gives a little asterisk next to dividend-paying ETFs and some of the challenges they face?

Rawson: Sure. Well, there is a timing issue of when you buy into a fund and when you receive the dividend. For example, if you buy right before a company goes ex-dividend, right before it pays out a dividend, essentially you are paying up ahead of time for a dividend distribution which you are about to get. So, in some sense you might want to wait until the fund goes ex-dividend, once it already pays out its dividend, and then buy into the fund after that has occurred. This helps avoid the potential of paying up for a fund in which you just get the dividend distribution right back sent to you and then that dividend can be taxed at a higher rate than a capital gain, potentially, depending upon what the dividend and capital gains tax rates are.

So, there can be an issue where if there is massive inflows into a fund, it could dilute the dividend that's coming back to you, but the total return is what you want to pay attention to. Of course, you get a return from dividend yield and capital appreciation. Together, those account for your total return. When your dividend yield is lower, perhaps you are going to get a higher capital gain, so the two should offset each other. So, you really don't need to worry about it from a total return perspective, but if you are expecting a certain level of dividends, that level of the dividend that you receive may fluctuate in an ETF depending on inflows and outflows to the fund.

Justice: So, to maximize that investor experience, you should really focus on being more of a long-term lifetime dividend investor than what you are going to get next quarter?

Rawson: Absolutely.

Justice: Because that's going to bounce around some based on what other investors are doing and the timing on which you get into that fund.

Rawson: Absolutely and what the underlying companies in that ETF are doing.

Justice: Well, all great points. I appreciate you joining me. I know everybody is interested in dividends, as am I.

For this and other ETF information, please be sure to check out our Morningstar ETF Center on Morningstar.com and our ETFInvestor newsletter.

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