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By Josh Peters, CFA and Jeremy Glaser | 09-18-2014 01:00 PM

Peters: Know What You Want From Dividend ETFs

There can be good reasons to own dividend-focused ETFs, but investors looking for pure income may be better off in individual stocks, says Morningstar’s Josh Peters.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

We are at the Morningstar ETF Conference with Josh Peters, editor of Morningstar DividendInvestor and a director of equity income strategy for Morningstar.

Josh, thanks for joining me.

Josh Peters: Good to be here.

Glaser: Let's look at that intersection between dividends and ETFs. There has been a proliferation of dividend-focused ETF products. What should investors look for if they are considering an ETF like that?

Peters: I think it depends on what you are trying to accomplish with that piece of your portfolio. Some people are interested in maximizing their current income. They are looking for the highest yields out there. They are willing to own things like mortgage REITs, BDCs, stuff I don't really care to own. But with an ETF product, you have the opportunity to gain some instant diversification, so that's a plus.

At the other end of the spectrum, there are a lots of products out there--the Vanguard fund VIG is an example, that are focused more on dividend growth. That's not going to give you as much income, but it is going to provide you with a very high-quality portfolio of individual common stocks at a very low cost, so there is an advantage there.

I like to operate in what I call the sweet spot, which is really those dividend yields in the 3%, 4%, maybe 5% range. That's well above the market average. The S&P 500 as a whole is yielding only about 2%. But that's still a range where dividends are generally safe--not always, you've got to check out the company--but generally safe. And you should get some growth as well.

In that range, now you are looking at an income return in your portfolio that you can use to reinvest or fund withdrawals that is much better than you can get from fixed income, but you're also getting the long-term growth of income and long-term total return prospect of equities. I like that balance.

So, to look for dividend ETFs, start by thinking where you want to be on the yield spectrum, and for me, that's typically in a 3%, 4%, 5% range.

Glaser: If you're in that range, though, how do you think about doing that as an ETF versus buying individual stocks. If you're paying a 30-40 basis point fee, that could eat up a lot of that yield.

Peters: I think that's an important point. I personally don't see a lot of merit in owning Johnson & Johnson or General Electric through an intermediary like that, which is going to clip your income. You could say, "Well, it's just, 30 to 40 basis points, 0.3% to 0.4% of your assets. That's tiny, that's a rounding error. Stocks go up and down that much for nothing." Well that's 10% of your income.

So if you're actually looking to provide a certain amount of income in your portfolio for practical reasons, personal reasons, then perhaps you own a basket of those kind of stocks directly, and you rely on the fact that they are relatively easy to own, relatively easy to evaluate. The dividends are telling you about the quality of the company. You don't have to be an advanced stock-picker to own those kind of big, trusted multinational names that pay big dividends.

Glaser: So when would you consider owning a dividend ETF over individual stocks?

Peters: Here you'd put me at the opposite end of the spectrum, where the income really isn't the priority, but let's say you're interested in emerging-markets exposure. This isn't where you want to go for nice, steady, reliable income. You've got currency risk. You've got economic risks in these countries, geopolitical risks, and perhaps not the same levels of disclosure or legal protections for shareholders--lots of reasons to be cautious.

But if you're out there looking for those kind of companies, to participate in that growth, then the dividend is sending very important signals. That might be just as valuable as the cash that's actually being remitted to shareholders. It's going to help you pick a better class of stocks in those countries. It's maybe not the best way to generate safe, steady, consistent income, if that's your priority, but it's a good way to get to the total return at the end of the line in that type of a market.

Glaser: So pure income investors might want to look at individual stocks; for others, ETFs could be an option?

Peters: Yes. And also, you have to always think of these things in terms of trade-offs. If you have a relatively small portfolio and you want more diversification than you can really get on a practical basis, then buy an ETF. A dividend ETF is going to put you in that right area of the market. It's going to match your basic style without having to do the individual security selection. For that matter if you have a larger portfolio, but you don't care to have to track individual companies, again this will put you in the right area of the market.

But look at the fund, look at the objectives, look at the holdings, look at the selection process. Does this make sense? The core of my strategy is I want companies that are protected by narrow and wide economic moats, with dividends that are reliable. Typically that's going to correlate to our low and medium uncertainty ratings. I want to pay less than our fair value estimates. This means quality, risk, and valuation should all be factors. I think those are good things to expect from any sort of investment product, ETF or otherwise, that you might be buying.

Glaser: Josh, I appreciate your insight today.

Peters: Thank you, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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