If things keep up the way they're going, there could soon be as many dividend ETFs as dividend stocks out there.
A U.S. firm called WisdomTree alone has issued 32 exchange-traded funds focusing on dividends, and competitors like Barclays, Claymore, First Trust, PowerShares and Vanguard have another dozen and a half or so listed on North American exchanges. "I can't believe how many dividend ETFs have come out recently," said Tyler Mordy, research analyst at Hahn Investment Stewards & Co., an asset manager that uses ETFs to build portfolios.
Investing in companies that pay dividends is the essence of sound investing, while ETFs are a highly efficient way to get broad exposure to stocks and bonds (they're index funds that trade like stocks). Can dividends and ETFs work together to the investor's advantage?
The answer is yes, but with the following four reservations.
1. Product clutter. The richer the selection, the harder it is to locate the fund that's right for your needs.
2. Cost. Ownership fees can chop your returns by a 0.5 of a percentage point on average, which is considerable when you look at how much dividend ETFs are yielding these days.
3. Lack of diversification. Some U.S. and global dividend ETFs are loaded with financial stocks, which have a heightened risk level right now because of problems radiating out of the U.S. subprime mortgage market.
4. Overdiversification. Uber dividend stocks that raise their quarterly payouts on a regular basis may be mixed in with sluggards that infrequently boost their dividends.
The main reason to consider dividend ETFs is that you can get exposure to Canadian, U.S., global and sectoral dividend-paying common stocks in a single purchase that should cost you no more than $5 to $29 at a discount broker these days. The management expense ratios on these aren't as cheap as some ETFs, but they're 75 to 80 per cent cheaper than what you'd pay to own a dividend mutual fund.
One example of a dividend ETF is the iShares Cdn Dividend Index Fund, which trades on the Toronto Stock Exchange under the symbol XDV. This fund's MER is 0.5 per cent and it tracks the Dow Jones Canada Select Dividend Index, which includes all the major banks plus a selection of other stocks such as Manitoba Telecom Services, Russel Metals, Rothmans, TransCanada Corp. and Magna International. The dividend yield is roughly 2.9 per cent.
This fund's main competition in the Canadian market is the Claymore Cdn Dividend & Income Achievers ETF, which has an MER of 0.6 per cent and a yield of roughly 3.2 per cent. Here, we have a good illustration of how investors need to do some digging to make sure they buy the product that suits their needs.
The holdings in the Claymore ETF are about 30 per cent invested in income trusts, which offer a good flow of income but don't have the same tax advantage as pure dividends. The largest position in the fund is Energy Savings Income Fund, a trust with a great record for increasing its cash distributions to unitholders but lacking in the blue-chip credentials of the typical dividend stock.
Another issue investors have to investigate is diversification. "I would say the sector allocation on dividend ETFs in the probably the No. 1 thing to look for," Mr. Mordy said. "We're getting a lot more alert about what's underneath ETFs these days."
The Claymore fund has 58 per cent of its assets in financials and about 17 per cent in energy and materials. The iShares fund is 49 per cent weighted in financials and 11 per cent in energy and materials. It also has a 14-per-cent weighting in telecom services stocks (they don't show up in the Claymore fund at all), which are conservative but not great dividend growers.
Diversification is at least as much of an issue with global dividend ETFs. Mr. Mordy said the U.S.-listed PowerShares High Yield Equity Dividends Achievers Portfolio has about half of its assets in small-size stocks, which are more volatile than big blue chips, and its financial weighting of close to 63 per cent compares with 20 per cent for the S&P 500. "With the credit crunch continuing in the U.S. and spreading globally, our firm has been heavily underweight financials since the middle of last year," he said in an e-mail.
