Scott Kubie has been using dividend-focused exchange-traded funds for several years. But recently he thinks these vehicles, which focus on dividend-rich pockets such as U.S. utilities, have become over-mined territory.

“Investors have been buying high-dividend stocks as a substitute for bonds, even though they’re clearly not,” says Kubie, the chief investment strategist of CLS Investments. “The big question is whether or not people are overpaying for high dividends. And in a lot of cases the answer is yes.”

Because dividends have historically accounted for about 40% of total stock market returns, they’re still an important part of his investment strategy. But there’s a difference between funds that simply offer the highest yielders and those whose companies can show dividend growth at a healthy clip. Kubie is now focused on the latter.

The high yielders are typically utilities and industrials. They are more sensitive to interest rates than most stocks—doing better than the market when rates fall and worse when they rise. Dividend growers, by contrast, come from “growthier” industries such as technology, health care and consumer goods. Although they yield about the same or slightly higher than the overall market, they can grow dividends faster because they benefit from strong cash flow and growing earnings. These traits make them less sensitive to interest rates than other high-dividend stocks.

Dividend Growth
The dividend growers have characteristics that help during slow economic growth, says Tyler Mordy, president of HAHN Investment Stewards.

“I think investors will be willing to pay a premium” for such businesses, he says. “The companies also have better growth potential than those that pay the highest dividend because they can use their cash for other purposes, such as acquisitions.”

The biggest dividend growth ETF, one favored by both Kubie and Mordy, is the $20 billion Vanguard Dividend Appreciation fund (VIG). It has a low 0.10% expense ratio, holds companies that have raised their dividends every year for at least the last 10 years and uses screens to weed out businesses that look vulnerable to dividend cuts in the future. Its largest sector exposure is industrials (23%), followed by consumer goods (19%) and consumer services (15%).

With a yield slightly below that of the S&P 500, this clearly isn’t a pure dividend play. Instead, the ETF and others like it use a history of rising dividends and other screens to pinpoint companies with low leverage, high profitability and other quality characteristics that help them stay up in rising markets and weather tougher times.

The recipe worked well for VIG during 2008, when it fell only 27% while the S&P 500 was falling 36%. Over the last five years, the fund has captured 87% of the market’s upside and 86% of its downside with less volatility.

The three-year-old, $2 billion Schwab U.S. Dividend Equity ETF (SCHD) isn’t advertised as a dividend growth offering, though it certainly resembles one. The fund seeks high-quality large-cap companies screened for their cash flow, debt, return on equity, dividend yield and dividend growth. These companies should have paid dividends for at least 10 consecutive years. The largest sector in the fund is consumer staples, representing 22% of assets, followed by industrials with 16% and information technology and energy at roughly 13% each. The fund has a razor-thin expense ratio of just 0.07%, making it the cheapest dividend ETF around.

One of the newer entries in the dividend growth camp is the WisdomTree U.S. Dividend Growth fund (DGRW), introduced in 2013. While its dividend yield is somewhat lower than others in the group and its 0.28% expense ratio a bit higher, WisdomTree’s long experience with dividend-focused investing is a plus. Because it puts greater emphasis on future dividend growth—rather than seeking a long history of dividend increases by a company—the fund has one of the larger weightings in information technology companies, which make up 22% of holdings. Many of these companies have only started to offer dividends in the last few years, but they have some of the strongest prospects for dividend growth.

Even though technology company stocks aren’t usually viewed as a dividend growth play, companies such as Apple have been leading the charge for dividend increases over the last few years. The First Trust NASDAQ Technology Index ETF (TDIV) sports a 2.6% yield, which is fairly generous for the group. Part of that yield comes from a 20% allocation to high-dividend telecommunications firms.

Dividend Yield
Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ, believes that ETFs with a large presence in higher-yielding sectors still appeal to some investors. “Historically, utilities and other stocks that pay above-average dividends tend to be less volatile than the market,” he says. “Investors continue to value those characteristics.”

Of course, if interest rates fall or stay about the same, higher-yielding ETFs could continue to command premium prices, as they have amid similar conditions in the past. And bargain hunters might find good picking grounds for tactical short-term trading or longer-term holdings during periods when utilities and other high-yielding sectors stumble.

Rosenbluth cites the iShares Core High Dividend ETF (HDV) as a standout in the high dividend crowd. It yields 3.2%. It’s spread among a fairly broad range of sectors, holding a 24% stake in consumer goods, a 19% stake in health care and a 12% stake in utilities. The ETF, which chooses stocks based on Morningstar’s “economic moat research,” targets high-quality companies with high and sustainable dividend yields. A Morningstar analysis of the ETF notes that while it has displayed low volatility and strong performance, the fund’s nearly 60% allocation to defensive sector stocks “is the highest of any domestic dividend ETF, which means HDV is likely to suffer more than competing funds as rates begin to rise again.”

Another giant in the high-yield dividend space, the iShares Select Dividend ETF (DVY), tracks an index of 100 U.S. stocks that, among other things, have paid dividends for five years. At 34% of the fund’s assets, utility companies are by far the dominant sector in the DVY portfolio. Trailing far behind are consumer goods at 15%, industrials at 14% and oil and gas at 9%. The dividend yield is almost a percentage point higher than the S&P 500. The average market capitalization of companies in the DVY fund is $15 billion, so the fund falls into Morningstar’s mid-cap value category. Because only 15% of its portfolio comes from the S&P 500, it tends to be less correlated to the overall market than most dividend ETFs.

Utilities as a whole have a low correlation to the S&P 500. The three largest pure-play utility bets are the Utilities Select SPDR fund (XLU), the Vanguard Utilities ETF (VPU) and the iShares U.S. Utilities fund (IDU). The trio, whose top 10 holdings are similar, boast yields ranging from 3.2% to 3.6%.

The ETN Route
Exchange-traded notes, unlike ETFs, track commodities or currencies indexes, but a few have crept into the dividend space. They are made up of unsecured debt obligations. They trade on exchanges like stocks. They are issued by banks such as Barclays, Deutsche Bank and UBS. And they are marketed under a variety of brand names.

UBS has elevated both income and volatility through several leveraged ETN products tied to the performance and yield of dividend-paying companies. The ETRACS Monthly Pay 2x Leveraged S&P Dividend ETN (SDYL) roughly doubles the positive or negative performance of the S&P High Dividend Aristocrats Index, and its variable monthly coupon is linked to two times the cash distributions of its constituents. The index, which follows companies that have both raised dividends consistently for at least the last 20 years and have high absolute dividend yields, straddles growth and high-yield territories.

Two other ETNs track indexes that fall squarely into the high-yield camp. One of them, the ETRACS Monthly Pay 2x Leveraged Dow Jones Select Dividend Index ETN (DVYL), tracks the Dow Jones U.S. Select Dividend Index and has a strong presence in utilities and other classic high-dividend payers. Another, issued by Deutsche Bank, the ELEMENTS Dow Jones High Yield Select 10 Total Return Index (DOD) follows the classic “Dogs of the Dow” strategy and, unlike the UBS offerings, is not leveraged. The index comprises the 10 highest-yielding stocks in the Dow Jones Industrial Average and is reconstituted each December. These stocks yield so much because their prices are depressed, so the ETN represents a deep value play.