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ETF Specialist

Avoiding the Dividend Trap

When picking high-yield or dividend-themed funds, it's important to focus on quality.

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Dividend-paying stocks are often seen as being higher-quality and stabler than their non-dividend-paying counterparts. Thus, they can be viewed as the next step up on the risk/return spectrum between lower-risk bonds and higher-risk stocks. But there is a point at which dividend-paying stocks actually become riskier than the average stock. Earlier this summer, shares of  BP  (BP) offered a trailing 12-month dividend yield of 9%. This would be a great deal if it was sustainable, after all  ExxonMobil's (XOM) yield is less than 3%. But the market was correctly forecasting that BP's dividend would be cut. Another example is New Century Financial, a subprime mortgage REIT that offered a dividend yield of around 18% at the peak of the housing bubble. That high dividend was nothing more than a trap, as the firm filed for bankruptcy when the housing bubble burst. In this article, we take a look at the ways that dividend-focused exchange-traded funds look to avoid this siren song.

Dividends have historically accounted for 40% of the returns from investing in stocks, and despite conventional wisdom, high-dividend-payout companies tend to have stronger earnings growth. So the case for investing in companies that pay dividends is a strong one. It seems that a logical way to achieve a high yield on a dividend fund would be to weight stocks by their dividend yield, so that high-yielding stocks would make up a larger percentage of the fund. But unfortunately, it does not follow that if dividends are good, a higher dividend yield must be better. The fact is that this approach does nothing to screen out the low-quality, risky companies that are likely to cut their dividends in the future, or even file for bankruptcy.

Michael Rawson does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.