Two Dividend ETF Picks for Your IRA

Christine Benz: Hi, I'm Christine Benz from Morningstar. You have until April 15 to fund an IRA for the 2009 tax year, so this week I'm talking to some of Morningstar's investment experts to get their best ideas for funding an IRA. I'm here today with Scott Burns. Scott is director of exchange-traded fund research for Morningstar. Scott, thanks for being here.

Scott Burns: Christine, thanks for having me, as always.

Benz: Well, it sounds like you've got a couple picks. One you've got is for people who are nearing retirement or perhaps in retirement, it's an income-rich fund. What is it?

Burns: Right now what we are really looking at is the utility sector, and we think the best bet in there is actually the Utilities Sector SPDR. The ticker is XLU. It's a low-cost ETF. It charges 21 basis points, and it's going to give you the utility portion of the S&P 500.

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The best part about it right now is that it's yielding 4.37%, to give you a very precise number. Which when we compare that to the offerings that are out there in the fixed income world, whether it's Treasuries or corporate bonds, it compares very favorably.

There still is a little bit of risk. There is no principal return. But when you look at utilities' balance sheets right now, they're are very solid. In fact if we have an economic recovery, the ability to actually get some capital appreciation from stock price appreciation is a lot better.

So unless you're extremely concerned about a double-dip recession--which I never say never, it may happen--we really think that if investors are looking for yield, that this is really the best opportunity. This is what we're looking at right now.

Benz: How are the utilities showing up in terms of the price to fair values lately? Are they looking cheap right now?

Burns: Yeah, they're still looking cheap. They're not as discounted as some of the other areas, like health care, where there's a lot more uncertainty. So whenever anyone is using the price to fair value on the Morningstar screening tool for ETFs, or just looking at an ETF, always make sure that you also look at the risk assessment that's going on and whether it's average, below average or above average, to give those to you out of order.

But when we look at utilities, these are very steady businesses. In fact, when you look back at utilities over the past five or 10 years, it's actually been one of the top performing sectors. That was true actually before even the financial meltdown in 2008. That steady dividend-paying stream with the kicker of capital appreciation really creates a nice risk-adjusted return for investors long term, short term.

Benz: OK. So you have another idea, and it might sound familiar to people who have been tracking your picks over the years. This one is for people who have slightly longer time horizons. It's another dividend-oriented fund.

Burns: Yeah. So we really like the Vanguard Dividend Appreciation Fund, the ticker VIG. We liked it last year; we liked it the year before. It performed extremely well. It was down in 2008 when everything was down, and it rallied in 2009, but it wasn't down as much in 2008, and it wasn't up as much in 2009.

It has provided a very steady basket of core companies using a really solid screener for growth. The ability to not only grow that dividend stream, but also for the companies to grow their asset bases in general. And also there are some financial screens in there, too. So it helps weed out.

This fund, even though it's a dividend fund, so many dividend-themed ETFs kept buying financials, kept doing bad things into the teeth of the credit crisis. This fund was able to side-step that a lot due to their balance sheet screens that they created.

So it gives you slightly lower yield, at 2.09%. So it's a lower yield, but it has a higher potential to grow overtime. So that's the thing to keep in mind.

Again if you're close to retirement, you may not actually have as much time to wait for that capital appreciation, but it's a very suitable core fund. You can look to substitute it for any of your large-cap holdings. It also kind of drifts into a mid cap a little bit.

So it's still the one to beat in terms of large cap, long-term ETF holdings we think.

Benz: OK. So two picks here, the Utilities SPDR XLU, and Vanguard Dividend Appreciation, VIG?

Burns: That's right. Two for one for you.

Benz: Thanks, Scott. Thanks so much for being here.

Burns: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.