Since the late 1990s, the size of corporate dividends has been nothing to write home about. Indeed, as a portion of many stocks' total returns, dividends have merited little more than an investment footnote. In March 2000, for example, the yield on the S&P 500 Index reached a low of 1.4%.
But falling stock prices have recently pushed dividend yields to levels they haven't seen in years, levels that have made them attractive alternatives to government securities. Consider that in mid-March, the yield on the SPDR S&P 500 (SPY) exchange-traded fund stood at 3.5%, while that of the Dow Diamonds (DIA) ETF offered more than 5%. Those investing in ten-year Treasury notes settled for paltrier yields of well under 3%.
These generous payouts have prompted some advisors to take a second look at dividend-oriented investment strategies as they await a market recovery. It's also important to consider that dividends have historically accounted for a large chunk of total stock market returns. And they can give shots of adrenaline to moribund portfolios.
"Securities that pay consistent dividends are a great way to wait out the market, especially when you consider that yields on many fixed-income investments are so low," says Scottsdale, Ariz., financial advisor Jay Penney, who believes equity markets will fluctuate in a fairly narrow trading range for the rest of 2009. "And when a sustained recovery begins, investors will gravitate toward blue chip companies that have the strength to protect and grow their dividends."
Penney prefers ETFs for his own dividend strategy, since he normally does not buy the stocks of individual companies and believes furthermore that this is a bad time to assume individual issue risk. Mutual funds are another alternative. But even though there are a number of equity funds that also boast higher yields, Penney says their appeal fades as the trading within them reduces their tax efficiency. Moreover, their dividend yields get decimated by annual expenses of 1% or more.
Like Penney, James Herrell of Partnervest Financial Group in Santa Barbara, Calif., uses dividend-rich ETFs to boost returns when the market is treading water. "Our strategies are akin to 'getting paid for waiting,'" he says, referring to the dividend income generated from the ETFs. "Even if the market goes nowhere, we can expect to make a decent return on our investment portfolios." For some clients, Herrell uses ETF dividends to replace some of the income once generated by government bonds. "I think the highest risk strategy now is to buy things that were once considered low-risk investments," he says.
The focus on dividend yields may seem strange given that so many companies, particularly in the banking industry, have been cutting theirs. But more stable sectors such as utilities, telecommunications and some industrials are offering high dividend yields as well. And while a dividend cushion of 4% may not seem like much when the stock market is in a free fall, the compounding effect can make a big dent in total return over time.
It's important to remember, however, that dividends are simply what a company earmarks for distribution to shareholders from earnings. The companies paying higher dividends are not necessarily stronger or more resistant to downturns than the ones offering more modest rewards. High-yielding bank stocks, after all, were once deemed safe. In a recessionary environment, though, it is also important to consider whether a company has deep enough pockets to sustain the dividend.
This is especially important to consider now, because as businesses seek to conserve their cash this year, some will skip or lower their dividend payouts. Standard & Poor's Index Services is predicting a 13.3% drop in dividends for some components of the S&P 500 index this year, the worst annual decline since 1942. An 8% dividend yield on the Financial Select Sector SPDR (XLF) may seem tempting, but it may not look so good a few months from now if the index's banks continue slashing their payouts and the component stocks tank. The federal government could also deal dividend investors a blow if it hiked the tax rate on qualified dividends up from the currently favorable 15% in an effort to shore up revenue.
Different Routes To Dividends
Despite these concerns, investors can allay risk by paying attention to sector allocation and index construction. Generally, the highest-yielding ETFs are stuffed with banks and other financial services companies. Some of them focus exclusively on the financial sector and are easy to identify by their names. But others that appear broad-based actually have a large chunk of their assets in financials, since their screens for high-yielding companies have suggested financial names. The highly popular iShares Dow Jones Select Dividend (DVY) had 37% of its assets in financials at the end of 2008 and lost 33% of its value in the fourth quarter. The loss, coupled with further deterioration for the sector in January, brought the allocation to financials to a more palatable 25% by the end of that brutal month.
The silver lining of the bank sector breakdown is that a number of other high-dividend ETFs once heavily stocked with financials have become much more moderate in their allocation to the sector since last year. The financials portion of WisdomTree Total Dividend (DTD), which has a 30-day SEC yield of about 5%, was recently below 20%. Other dominant sectors in the index, which ranks its constituent companies based on projected cash dividends, include consumer non-cyclicals, energy and industrials. Utilities make up the largest component of the First Trust Value Line Dividend Index Fund (FVD), followed by financials at 22% and industrials at 14.5%.
Beyond these higher-yielding ETFs are a number of other options that also offer attractive dividends.
Diversified ETFs with low bank stock allocations. Steep price declines have brought down financial sector allocations for some ETFs. But some were already less steeped in financials than peers because of index screens. These funds, however, might typically yield less than counterparts that scout out the highest dividends, because they emphasize consistency rather than steep payouts.
The PowerShares Dividend Achievers Fund (PFM), which Penney uses, has about 13% of its assets in financials, 17% in health care and 21% in consumer staples. It beat the total return of the S&P 500 index by more than seven percentage points last year, although it lagged the market in the beginning of 2009. He also uses the PowerShares International Dividend Achievers Fund (PID) to get international exposure to dividend-paying stocks. Although the ETF has a sizable presence in foreign banks, he believes that the institutions it invests in are more financially stable than their U.S. counterparts and that their dividends are more sustainable.
The Vanguard Dividend Appreciation ETF (VIG) has 12% of its assets in financials, with consumer staples, energy, health care and industrials dominating its portfolio. It consists of stocks that have a track record of increasing dividends for at least the last ten years and that have potential for dividend growth.
Preferred stock ETFs. A few rungs up the risk ladder, preferred stock high-dividend ETFs have a substantial presence in the financial sector, but with a backstop. Herrell employs an aggressive income strategy that combines high yield with the potential for substantial price appreciation using the iShares U.S. Preferred Stock index (PFF), yielding 14.2%, and the PowerShares Financial Preferred Portfolio (PGF), yielding 21%. While he acknowledges the risk of the sector, he points out that the preferred shares are senior to the U.S. government's preferred shares granted as a result of its bailout. So while shareholder equity is at risk, the preferred stocks are more likely to survive intact, he says. Although the ETFs have fallen by a considerable amount, they can hold up better than the overall market and straight equity financial sector ETFs. Last year, for example, PFF declined by 24%, whereas the S&P 500 dropped 37%. Meanwhile, the PGF declined 28%, about half the drop of the Financial Select Sector SPDR.
Broad-market ETFs. With dividend yields higher across a number of sectors, it is possible to stay diversified and still get attractive ETF dividend yields. In mid-March, the SPDR S&P 500 had just 10% of its assets in the financial sector. Information technology, health care, consumer staples, industrials and energy all had larger presences. The S&P 500 Value Index Fund (IVE) has a 17% weighting in financials and a dividend yield of 5.6%. Dow Diamonds (DIA) had about 4.5% of its assets in the financial group, while sectors such as industrials, consumer staples and information technology all had higher profiles.
Sector ETFs. These offer a more focused route to above-average dividends. The plunge in real estate values and real estate investment trusts has halved the value of many real estate exchange-traded funds such as the iShares Dow Jones Real Estate ETF (IYR), the SPDR Dow Jones Wilshire REIT ETF (RWR) and the Vanguard REIT ETF (VNQ) over the last year. Yields in the neighborhood of 10% might attract contrarians willing to bet on a real estate recovery, or those looking to diversify with an investment that has a substantial dividend safety net. ETFs such as Vanguard Utilities (VPU) and iShares DJ Utilities (IDU) offer exposure to a tamer corner of the stock market that still pays attractive dividends. Other high-yielding sectors represented by ETFs include telecommunications, energy, industrials, internationals and emerging markets.
