Fund providers are adding a heaping helping of spice to the plain-but-satisfying dividend ETF – and investors should be wary.
Nearly 60 exchange-traded funds in Canada and the United States now offer a dizzying number of ways for dividend lovers to feast on their favourite fare. Investors can play China's growth story with funds such as WisdomTree China Dividend ex-Financials ETF, or the volatile tech sector through First Trust Nasdaq Technology Dividend ETF. For those who want the biggest dividends possible, Global X SuperDividend and the soon-to-be listed Vanguard FTSE Canadian High Dividend Yield offer up companies with outsized payouts.
Dividend ETFs have attracted a large following among investors who want steady income as well as those who believe that companies with regular payouts must be more financially stable than their peers. But investors need to look at the specifics of each ETF. Some of the new offerings produce yields that are not much different than a broad market index fund. Others are heavy with stocks that have already enjoyed big gains and so may be poised for a fall.
"Investors are thirsty for yield," said John Gabriel, an ETF strategist with Morningstar Inc. "They are not getting it in the bond market. If they can get it through stocks, it's certainly a strong selling point. … But just looking at the word dividend alone in the fund is not enough."
For instance, the U.S.-listed Vanguard Dividend Appreciation ETF sounds like it should appeal to investors looking for fat payouts. In fact, it throws off just about the same income as a simple S&P 500 ETF, said Mr. Gabriel. The difference is that the Vanguard ETF focuses on companies that have increased their dividend for at least 10 consecutive years, and "you get higher quality companies," he added.
Some of the new dividend ETFs may appear more novel than they really are. The recently listed U.S.-listed PowerShares S&P 500 Low Volatility High Dividend ETF hits two hot-button themes popular among anxious investors – it chooses less risky stocks with big payouts. However, "if you really dig deep, it's more marketing than anything else," Mr. Gabriel said, noting that a search for low volatility stocks would probably turn up mostly the same stocks as a hunt for high dividend payers.
Todd Rosenbluth, an ETF analyst with S&P Capital IQ, warns that some dividend ETFs own stocks that have had a strong run-up and may no longer be attractive. For instance, he is not a fan of the U.S.-listed PowerShares KBW High Dividend Financial Portfolio ETF even though it is up about 17 per cent this year, and has a dividend yield of 9 per cent.
"We see a lot of stocks that are overvalued" in that ETF, he said. "It owns a lot of mortgage real estate investment trusts, and those tend to pay high dividends. … The underlying holdings have done well, but does not mean they will continue to do well. And it's an expensive product costing over 1.30 per cent."
Deborah Frame, who oversees ETF portfolios as vice-president of Cougar Global Investments, said that investors can rarely go wrong with owning dividend ETFs, but there are short-term macro-economic events that can hurt their stocks.
ETFs focused on Canadian companies now look more attractive than U.S. firms because of the potential impact of the "fiscal cliff" that could end tax breaks for U.S. businesses next year, she said. "If companies need to use cash that is currently being used for dividends in order to pay higher taxes, then that is what will happen."
Still, dividend ETFs can be a better bet than a plain-vanilla version when it comes to more volatile sectors or markets. The WisdomTree China Dividend ex-Financials ETF, for example, focuses on dividend-paying Chinese companies as a way to weed out more questionable firms in the country.
However, a dividend ETF with more bells and whistles will often come with larger fees, Mr. Gabriel said. "Part of the decision is whether the higher cost justifies the strategy."
TOP DIVIDEND ETFs
Analysts pick their favourites
John Gabriel, ETF strategist, Morningstar Inc.
iShares S&P/TSX Canadian Dividend Aristocrats ETF (CDZ-TSX): It gives broad market exposure and focuses on firms that have increased their dividends annually for at least five years.
Vanguard Dividend Appreciation ETF (VIG-NYSE): It invests in U.S. blue chips that have raised payouts yearly for a decade, and charges a low fee of 0.13 per cent.
Todd Rosenbluth, ETF analyst, S&P Capital IQ
SPDR S&P Dividend ETF (SDY-NYSE): It sets a high bar, investing in companies that have increased their dividends annually for at least 25 consecutive years.
WisdomTree Dividend Ex-Financials ETF (DTN-NYSE): It gives exposure to all sectors of the U.S. market, but shuns the highly leveraged financial sector.
Deborah Frame, vice-president, Cougar Global Investments
iShares Dow Jones Canada Select Dividend ETF (XDV-TSX): It has a heavy weighting in Canadian financials, including banks that make up a third of the ETF.
BMO Canadian Dividend ETF (ZDV-TSX): It includes stocks with at least three years of dividend growth, resulting in a 34-per-cent weighting in financial stocks.