Seven High-Quality Dividend-Paying ETFs

We are always looking for ways to enhance the investor experience for our Morningstar.com users. Our most recent effort is focused on improving the capability of our ETF screener, and you can give our new screener a test drive by clicking here.

Keep in mind that this version is still in beta testing, and we would love to hear from you as to how we can make it even better. But we think that you'll like the capabilities that we've already introduced. Prior to replacing our current screener in the coming months, we will be introducing new data categories that will improve our search results in alternative asset classes, such as commodities and dynamic strategies. By doing so, investors will be able to bring their own ideas to Morningstar and quickly find an ETF that suits their personal thesis.

To help you understand how to use this new product, we've constructed an example that follows a common theme sought by many investors. We set out on a search for quality dividend-paying ETFs.

Search Criteria
Upon landing on the homepage of our new screener, we first eliminated all of the default criteria by clicking on the checkboxes to the right of the slider bars in the ETF Screener section. We then added our own criteria that conformed to our desired search, by clicking on Add Criteria.

Because we're looking for dividend payers, the first criteria we added was Yield (%), which can be found in the Quote section. In order to make this section relevant, we changed the range in the screener to set the minimum dividend yield at 3.31%, or the equivalent dividend yield of the S&P 500 on the screening date. Ranges can be changed by moving the slider bar or by entering a value manually. This screen alone reduced the qualifying ETFs down to 242 from a universe of 842.

Next, we added what we determined to be a quality sort. Financial stocks have historically been high-dividend payers, but the ongoing financials crisis has left us a bit weary on the sector's prospects. We added the criteria Financial Service from the Sectors Weightings % criteria, and we then set a maximum of 15%. This way, we won't have too much exposure to banks. Notice how the ETF results change in real time as you use the slider, which helps you ensure that your results are relevant with each successive category you add. We are already down to just 55 ETFs.

In order to stay away from many cyclical commodity names, we now added the Price/Trailing Earnings sort from the Valuation section. In this case, we set a minimum P/E ratio of 7.5 and a maximum of 12. By doing so, our results would not be encumbered by too many energy and materials funds. Commodity stocks are notorious for large deviations in earnings as commodity prices change, and trailing P/E ratios are biased because they are backward-looking.

We further enhanced our valuation sort by incorporating the opinion of Morningstar's equity analysts. Our ETF coverage is enhanced by having 100-plus analysts covering more than 2,000 stocks, and we can assess the underlying value of each fund by rolling their fair-value estimates into the weighting of each ETF's portfolio. So under the Valuation criteria, we also added the  Price/Fair Value criteria, and we gave it an upper limit of 0.75. After all, what better reason is there to purchase a fund than believing that you are getting it at a steep discount? This sort brought our results down to just 12 funds. (Some of our criteria, including Price/Fair Value, are available only to Premium Members of Morningstar.com. For a free 14-day trial, click here.)

Finally, we added a criterion that is a hallmark of the ETF industry. With so much competition in the field, low fees have emerged as a primary investor attractant. We see little reason to overpay when so many quality funds sport low price tags, so we added the Expense Ratio sort from the Nuts & Bolts section. We capped our fees at 0.30%, which is lower than what most ETFs or mutual funds would charge, and our results were whittled down to just seven quality funds.

Our Results
Given that we sorted for dividend-paying stocks, it should come as no surprise that our results were tilted away from the growth portion of the Morningstar Style Box. Furthermore, our limitations on the financials sector mostly produced large diversified funds that could be considered core holdings.

 SPDRs (SPY)
Because we set our minimum dividend yield equivalent to that of the S&P 500, it's no surprise that our results contained our benchmark. SPDRs is the oldest and largest ETF available, and its rock-bottom expense ratio of just 0.08% is the envy of any cost-conscious investor. This fund tracks the S&P 500, a diversified large- and mid-cap index of U.S. companies listed on the major U.S. stock exchanges. This fund is a fine core equity holding due to its diverse sector allocation, relatively low-volatility stocks, and low expenses. Although it lacks exposure to small-cap stocks, the S&P 500 is frequently used as a proxy for the full U.S. market and has had over a 98% correlation with the broad market over the past couple years. The fund may lag the market in times of small-cap outperformance, but because it holds more than 80% of the market, the fund should never fall behind by more than a few percent per year.

 WisdomTree LargeCap Dividend (DLN)
The highest dividend-yielder in our sort should come as no surprise. After all, its namesake and index methodology set out for current yield as its primary bogy. This fund starts with 300 of the largest domestic companies in terms of market cap, but it then uses a fundamental weighting strategy based on the highest dividend payers of the bunch. Because the fund focuses on industry leaders with the wherewithal to pay dividends, it's not surprising that 91% of its assets are dedicated to firms that possess competitive advantages, or "economic moats." In fact, more than half of the portfolio is dedicated to firms that earn wide economic moat ratings from our analysts. Wide-moat companies are likely to maintain their competitive edge for some time due to factors such as a huge market share. We love the fund's high yield of 4.84%, but it also weighs in as the most expensive fund from our sort with an expense ratio of 0.28%. However, that is still cheap by most measures.

 Industrial Select Sector SPDR (XLI)
We were not surprised to see that only one sector fund made our cut, and few sectors have been battered recently like the industrial's space. Earnings projections have contracted rapidly in the manufacturing space, and a recovery here will likely happen only when the broader economy turns a corner. That said, our analysts still feel that this group's market prices have been overly punished, so risk-tolerant investors could realize strong returns by buying it today and holding out for an eventual recovery. However, we would caution investors that some dividend cuts still loom on the horizon, which would reduce the fund's 3.98% dividend yield. The fund is top-heavy, as its top 10 holdings gather more than 48% of the fund's assets, and  General Electric (GE) alone represents more than 11% of holdings. With fewer than 60 companies concentrated in one industry, we would use this fund only as a complement to an already diversified portfolio. With an expense ratio of just 0.22%, this is as cheap as sector-focused funds come.

 DIAMONDS Trust, Series 1 (DIA)
This ETF replicates the Dow Jones Industrial Average, an index of 30 stocks maintained by the editors of The Wall Street Journal, who consider subjective factors such as the strength of each firm's reputation and the degree to which the business is representative of the U.S. economy in deciding which stocks to include. Unlike most other indexes, which are weighted by market capitalization, the DJIA is weighted by the price of each stock, resulting in individual stock weightings very unlike those of other familiar indexes such as the S&P 500. However, this index supports a dividend yield of 3.87% compared with just 3.31% on the S&P 500. The corporate behemoths in the DJIA generate a large percentage of revenues internationally, giving this ETF considerable international exposure despite being composed of U.S. companies. This fund's 0.14% expense ratio is lower than any other ETF tracking the Dow Jones Industrial Average by 6 basis points, though Vanguard and SPDRs offer broader U.S. large-cap index tracking for about half the cost. However, when annual costs are this low, tracking error and market price fluctuations are likely to take a bigger bite out of assets than the expense ratio.

The Rest
Three other funds take a sampling of the largest of large-cap names available on the U.S. market.  IShares S&P 100 Index  (OEF),  iShares NYSE 100 Index , and  Rydex Russell Top 50 (XLG) have enough overlap in their portfolios to act as relatively good substitutes for one another. They all sport fees of just 0.20% and price/fair value ratios of 0.70. If you're looking for the highest dividend-yielder, then iShares NYSE 100 is your target. However, this fund has the highest weighing of financial-services firms of the three, coming in at 10.57% versus approximately 8.8% for the other two.

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