Reaping high-dividend income with ETFs

Stocks that pay above-average dividends have historically been less risky than the overall market and in many studies have been more profitable as well.

Another advantage of dividend-paying stocks for your clients who depend on their investments for income to meet living expenses is that the dividend payments on a broad basket of stocks (such as the S&P 500 Stock Index) have risen over time at roughly the same long-term rate as stock prices themselves, which has been faster than inflation. The market’s big decline since October 2007 coupled with relatively stable dividend payments have boosted yields to the highest levels since 1995: 3.2%/year on the S&P 500, for example.

Reaping high-dividend income with ETFs

ETFs are a natural vehicle for implementing high-dividend stock strategies because of their low expenses (relative to mutual funds), which leaves more income available to distribute to shareholders. In 2003, iShares, from Barclays Global Investors of Jersey City, N.J., launched the first dividend-oriented ETF, the iShares DJ Select Dividend Index Fund (DVY). It was an immediate success, in part because its appearance coincided with a tax break on qualified equity dividends.

There are now 19 U.S. equity exchange traded funds with portfolios geared either to high current dividend yield or to persistent dividend growth. In addition, WisdomTree Investments of New York, for example, has a dozen international equity ETFs based specifically on dividend-paying stocks. DVY retains a strong advantage in liquidity over most other dividend-oriented ETFs.

Pitfalls in dividend-oriented investments

One of the biggest challenges in putting together a portfolio of high-dividend stocks is to avoid investing too much of your assets in financial companies that which comprise the bulk of high-dividend stocks even in the midst of the current financial crisis. (Utilities are a second staple of dividend-rich equity portfolios.)

The table below summarizes selected ETFs with high current dividend yields, along with the S&P 500 SPDR as a benchmark. There have been significant performance differences between these ETFs. Since the start of 2006, the SPDR S&P Dividend ETF has had the best record of the three U.S. equity ETFs in the table. If you choose to invest in some of these, you should consider those ETFs with relatively low exposure to financial stocks to avoid the risks of price volatility and potential dividend cuts in 2009.

Recommended high-dividend ETF portfolio

The WisdomTree Emerging Market High Yielding Equity Fund (DEM) lost 37% in 2008, compared to a relatively small loss of 25% for the SPDR S&P Dividend ETF (SDY). Yet, paradoxically, a portfolio with both ETFs in it would historically have been safer than either ETF alone.

Specifically, investing $2 in the emerging markets high-dividend ETF (DEM) for every $8 in the U.S. equity high-dividend ETF (SDY) would have resulted in a smaller peak-to-valley loss than any ETF alone experienced in the past three years. Similar results are seen using other high-dividend U.S. equity ETFs with longer histories: combining 20% emerging market high yield (hypothetical data provided by WisdomTree) with 80% U.S. equity high yield has resulted in less risk than either category alone experienced.

Even though past results do not guarantee future performance, it does seem reasonable to expect that emerging market stocks will continue to serve as good portfolio diversifiers during normal market conditions when combined with U.S. equities. As a result, if you are looking to hold a high-dividend equity portfolio for a many years, I recommend using up to 20% emerging market high-dividend stocks.