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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 more stable than their non-dividend-paying counterparts. For income-orientated investors, they are viewed as the next step up on the risk/return spectrum between lower-risk bonds and higher-risk growth stocks. But there is a point at which dividend-paying stocks actually become riskier than the average stock. Just after last year's Gulf oil spill, shares of  BP (BP) offered a trailing-12-month dividend yield of 9%.

This would have been 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.

Consistent Dividend Increases
One approach to overcoming the challenge of the dividend trap is to select companies that have shown a consistent pattern of increasing dividends.  Vanguard Dividend Appreciation ETF  (VIG) and PowerShares Dividend Achievers (PFM) select stocks from a list of companies that have increased dividends for 10 or more years.  SPDR S&P Dividend (SDY) kicks this up a notch by requiring at least 25 years of dividend increases. However, this results in just 60 holdings as not many companies have been able to increase dividends during that long a time period. For example, no technology firm made the cut in SDY, while both VIG and PFM hold  IBM (IBM).

While  PowerShares HighYield Dividend Achievers (PEY) requires 10 years of dividend growth, it is similar to SDY in that it uses a dividend-yield-weighting methodology rather than the modified market-cap-weighting approach followed by VIG and PFM. This results in a higher yield but also higher volatility, as the highest-yielding stocks tend to be riskier. Because of their focus on high-quality stocks and their use of market-cap weighting, both VIG and PFM have a higher percentage of assets invested in stocks with wide economic moats (sustainable competitive advantages). In contrast, SDY has 25% and PEY has just 8% of assets in wide-moat stocks.

It is no surprise that these funds tend to be overweight in consumer-staples stocks and hold stocks with strong brand recognition. All three of these funds hold  Coca-Cola (KO),  PepsiCo (PEP), and  McDonald's (MCD). Firms with strong brands that are able to generate steady, repeat business are likelier to grow their dividends over time. In fact, 61% of the assets in VIG have a wide moat, compared with just 40% for the S&P 500.

  3-Yr Annlzd Return (%) Std Dev of Return (%) Trail 12-Mo Yield (%) Exp Ratio (%) Wide-Moat Stocks (%) Vanguard Div Apprec ETF (VIG) 3.87 18.51 1.97 0.23 61 First Trust Value Line Div Idx (FVD) 6.12 19.27 1.97 0.70 26 PowerShares Div Achv (PFM) 0.13 19.61 2.08 0.60 56 WisdomTree LargeCap Div (DLN) 0.25 21.86 2.61 0.28 40 Vanguard High Div Yld Indx (VYM) 1.20 22.22 2.65 0.18 54 WisdomTree Total Div (DTD) 1.47 22.60 2.74 0.28 43 SPDR S&P Div (SDY) 5.91 22.98 3.21 0.35 25 iShares DJ Select Div Idx (DVY) 0.74 23.3 3.36 0.40 18 PowerShares HiYld Div Achv (PEY) -4.72 31.13 3.95 0.60 8 __________           SPDR S&P 500 (SPY) 2.36 21.84 1.76 0.09 40 iShares iBoxx $ InvGrCorpBd (LQD) 6.50 10.71 4.85 0.15 N/A iShares iBoxx $ HiYld Cor Bd (HYG) 8.11 16.93 8.00 0.50 N/A


Weighting by Dividends Paid
A second approach to avoiding the dividend trap is to weight stocks based on the total dollar amount of dividends paid rather than by dividend yield. This results in a tilt toward larger-cap companies, as they tend to be the ones that pay out the largest dividends on an absolute basis rather than on a percentage basis.  WisdomTree LargeCap Dividend (DLN) follows this approach; its two largest holdings are  AT&T (T) and  ExxonMobil (XOM). Also,  iShares Dow Jones Select Dividend Index (DVY) weights by dividends but uses some additional screening criteria for inclusion in the index (such as requiring five years of dividend growth and an average dividend payout ratio of less than 60%). Those screens were not enough to prevent the fund from being overweight in financials right before the financial crisis. Perhaps due to the poor performance of DVY, iShares recently launched  iShares High Dividend Equity (HDV) which seeks out stocks with economic moats and low probabilities of default. Although the Morningstar index it follows has a good track record, it remains to be seen if this fund can deliver as promised.

 Vanguard High Dividend Yield Index ETF  (VYM) uses a diversification and market-cap-weighting approach to minimize the impact a few low-quality stocks can have on the portfolio. The fund ranks stocks by dividend yield then includes all stocks until it accumulates 50% of the market cap of the broader universe. Weighting by market cap means stabler, larger names dominate the list, but also that the fund includes hundreds of smaller-cap stocks that pay high dividends. All-in, VYM holds 441 stocks. The comprehensive WisdomTree Total Dividend (DTD) weights stocks by dividends paid and includes all stocks that trade on U.S. exchanges and meet certain liquidity requirements, resulting in a whopping 831 holdings.

Other Methods
First Trust Value Line Dividend Index  (FVD) picks stocks with a higher-than-average dividend yield, but it requires that they be ranked in the top two out of five safety rankings, which are based on stock-price stability and balance-sheet quality. The fund then equal weights these stocks.

Unfortunately, many of the dividend-focused ETFs were overweight in financial stocks heading into the 2008 financial crisis, and this hurt their performance relative to the S&P 500 over the past three years. For example, PEY had 62% of assets in financial stocks and DVY had 46%, while VIG had just 17% of assets in financial stocks. It is important to note that the trailing 12-month dividend yield is reported net of the expense ratio. So while the 1.96% yield on VIG is only slightly higher than the 1.87% yield on the S&P 500, at least it is net of fees. Additionally, VIG should really be thought of as more of a quality fund rather than a dividend fund. The hope with VIG is that its constituent companies will be able to grow dividends as they have in the past.

For comparison purposes, we have included the S&P 500 Index in the table, as well as two bond ETFs:  iShares iBoxx $ Investment Grade Corporate Bond (LQD) and  iShares iBoxx $ High Yield Corporate Bond (HYG). Both bond funds had much stronger performances and the lower risk you would expect from being higher up in the capital structure. But going forward, they offer less potential for capital appreciation. Furthermore, as the name implies, fixed-income securities pay a "fixed" dividend, while stock dividends have the potential for growth. Remember, all of the upside beyond the fixed-income contractual obligations accrues to stockholders.

Dividend funds can also be a good way to invest internationally, particularly when the investor is concerned about the quality and transparency of international financial markets. WisdomTree Emerging Markets SmallCap Dividend (DGS) weights stocks by dividends paid and has earned 5 stars for its solid three-year performance.

For Your Watchlist
For income investors who want to invest only a small portion of assets into just the highest-quality stocks, we recommend Vanguard Dividend Appreciation ETF. Not only has this fund had a better-than-average return over the past three years, it has also had the lowest volatility of the nine funds mentioned in this article. On the flip side, for investors who want an even higher yield and are willing to accept the higher risk inherent in that strategy, we'd recommend a closer look at SPDR S&P Dividend.

Note: An earlier version of this article contained an erroroneous 3-year annualized return for VIG. The correct figure is 3.87%.

A version of this article last ran on Dec. 8, 2010.

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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock Asset Management, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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