Selecting the Right Dividend ETF

The battle of the dividend-focused exchange-traded funds may already be over. At least in terms of assets and fund flows,  iShares Dow Jones Select Dividend Index (DVY) looks dominant. Its main rival, PowerShares HighYield Dividend Achievers (PEY), has amassed a respectable $287 million in net assets since its December 2004 launch. However, that's still less than a third of the $947 million in net new money that iShares Dow Jones Select Dividend gathered in the first two months of 2005.

Asset flows don't tell the whole story, though. Despite the size disparity, it's hard to render definitive judgment on which ETF is better because their real-world track records are so short (the iShares ETF has been around for less than two years and the PowerShares fund for little more than one quarter). That doesn't stop people from asking, however, so let's look at how these two yield-centric ETFs stack up so far.

On the surface, the funds look similar: They both try to offer exposure to stocks that have above-average yields and the ability to continue paying and increasing their dividends. The benchmarks they track, however, use different recipes.

The Details
The Select Dividend Index, which was created in 2003, looks for 100 stocks in the Dow Jones U.S. Total Market Index that have increased their dividends over the last five years without ever missing or cutting a payout. To ensure its constituents are liquid and financially viable, the Select Dividend Index requires its members to have three-month average daily trading volumes of at least 200,000 shares and to have retained an average of 40% of their earnings in the previous five years. The bogey weights its components based on the dollar amount of their dividends and rebalances once a year in December.

The PowerShares fund, on the other hand, tracks the Mergent Dividend Achievers 50. That benchmark includes the 50 highest-yielding members of the Dividend Achievers, a list of stocks that have increased their dividends in each of the last 10 years. Equity data and research firm Mergent has compiled the list for more than 20 years, but the Dividend Achievers 50 has been published only since late 2004. The index's quality screen is its insistence on a consistent record of dividend increases. It arranges its holdings by yield and rebalances quarterly.

More than half of the Dividend Achiever 50's holdings can be found in the Dow Jones Select Dividend Index, and both funds tend to bunch their assets up in the same sectors--financial, utilities, and consumer goods stocks. There are still significant differences, though. The Dividend Achiever 50 Index includes many utility and small regional bank stocks that don't make the Select Dividend Index's cut, such as  Consolidated Edison (ED) and First Commonwealth Financial (FCF). The Select Dividend's liquidity and quality screens also cause it to lean more toward large-cap stocks.

Although both funds focus most of their money in a couple of sectors, the Dividend Achievers is the more concentrated of the two. It owns half as many stocks as the Select Dividend Index and keeps more than 80% of its stocks in utilities and financial issues. The Select Dividend Index puts 60% in those areas. That has helped give the Dividend Achievers index a higher yield--more than 3% compared with 2.4% for the iShares. The extra income could come with extra volatility, though. These funds have only been competing head to head since the end of 2004, but thus far in 2005, the Dividend Achievers ETF showed more downside, slipping 5% through April 8, 2005, while Select Dividend dropped 2.4%.

These are index funds, but management still matters. It's not hard to figure out who's David and who's Goliath. PowerShares is less than three years old and has a handful of employees. Barclays Global Investors, the advisor to iShares, has been managing index funds since they were first conceived about 30 years ago and now is the largest manager of index assets in the world. PowerShares' crew very well may acquit themselves in the long run, but right now Barclays has the better credentials.

Finally, the iShares fund is cheaper. PowerShares HighYield Dividend Achievers, which has capped its expense ratio at 0.50%, isn't expensive relative to traditional mutual funds, but its levy is still higher than the 0.40% charged by iShares Dow Jones Select Dividend Index.

The Way To Go?
Both of these funds still have a lot to prove. If pressed to choose between them, though, I'd lean toward iShares Dow Jones Select Dividend Index because it has the longer track record, more established and accomplished advisor, lower expense ratio, and more diversified portfolio. Investors should be careful with both, though. They each have a whiff of the Dogs of Dow about them. That once-popular strategy, which involves buying the highest-yielding stocks in the Dow Jones Industrial Average, has been discredited in recent years because it failed to avoid stocks that had high yields because their businesses were in peril and their stocks plummeting. Requiring histories of dividend increases may help these ETFs avoid such pratfalls, but, before considering either of these ETFs, income-seeking investors still might want to investigate funds that apply more rigorous qualitative research in their search for yield.

For example,  Vanguard Equity-Income (VEIPX) offers investors a portfolio crafted by three seasoned subadvisors practicing time-tested strategies for identifying cheap stocks with above-average dividend payouts. It also charges a lower expense ratio than both of these ETFs. Meanwhile,  Franklin Rising Dividends (FRDPX) has used strict dividend growth and valuation screens, rigorous fundamental research, and a buy-and-hold approach to produce competitive absolute returns with below-average volatility over the last 15 years. You can find tips for finding more dividend-focused funds here.

Disclosure: Barclays Global Investors (BGI), which is owned by Barclays, currently licenses Morningstar's 16 style-based indexes for use in BGI's iShares exchange-traded funds. iShares are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in iShares that are based on Morningstar indexes.