(Dow Jones) Exchange-traded funds that focus on dividend-paying stocks trailed the market by a wide margin in 2009, but they may attract yield-starved bond investors who are also worried about the prospect of rising interest rates.
Several factors are causing some fixed-income investors to take a second look at stocks to generate income. Yields on CDs, money markets and high-quality bond funds are at paltry levels thanks to the Federal Reserve's commitment to keep rates low to fight the recession.
Meanwhile, investors are anxious about potential losses in bond funds if interest rates rise. Bond prices and yields move in opposite directions.
There are dozens of dividend ETFs-the largest is iShares Dow Jones Select Dividend Index Fund (DVY), with nearly $4 billion in assets. Other big ETFs in the category include Vanguard Dividend Appreciation ETF (VIG), SPDR S&P Dividend ETF (SDY) and WisdomTree LargeCap Dividend Fund (DLN).
Many companies were forced to scale back or abandon dividends during the financial meltdown to conserve capital, but the trend may be turning.
Last year, S&P 500 companies paid out $196 billion in cash dividends, a "massive" $52 billion decline from the $248 billon paid in 2008, according to Standard & Poor's Index Services.
Dividends have accounted for more than one-third of total U.S. equity returns since 1926, according to S&P.
"Investors will put an increasing emphasis on dividends for both current income and longer-term capital appreciation," said Howard Silverblatt, senior index analyst at S&P, in a study this month. "This additional emphasis will add pressure to non-paying dividend issues with sufficient and stable enough resources to initiate payments."
'Different Level of Risk'
Investors need to do their homework when choosing among dividend-themed ETFs, experts warn.
Because they invest in stocks, the funds have an "entirely different level of risk" than bond portfolios, said Bradley Kay, analyst at investment researcher Morningstar Inc.
Some are calling for a stock pullback now that the rally has pushed the S&P 500 Index up about 70% from the March 2009 market low. Also, stocks with high dividend yields can be the riskiest and most-distressed companies within a particular industry, Kay said in an interview.
The iShares Dow Jones Select Dividend fund gained 11.2% in 2009 but trailed the S&P 500 by 15.5 percentage points, according to Morningstar. Additionally, many dividend ETFs fell hard during the credit crunch as a result of their outsized exposure to the financial sector.
"There is no free lunch in the market, so the largest dividend yields tend to come from stocks that have fallen substantially, showing that investors do not believe the payments can be maintained," Kay wrote in a recent report.
The iShares Dow Jones Select Dividend had a 30-day SEC yield of 3.85% as of Feb. 26, according to the most recent data from the ETF's sponsor, BlackRock Inc. (BLK).
Other firms that manage dividend ETFs include Claymore Securities Inc., First Trust, Invesco PowerShares, State Street Global Advisers, Vanguard and WisdomTree Investments Inc. (WSDT).
When choosing among the numerous dividend ETFs, Kay advised starting by looking at the total number of stock holdings and the sector allocations to get a handle on risk.
Some ETFs use screens to target specific classes of dividend stocks, while others take a more diversified approach.
Kay also suggested looking at how volatile the funds have been relative to the overall market. "You want price safety if you're looking for income," the analyst said.
Dividend ETFs aren't confined to just U.S. shares. The WisdomTree International SmallCap Dividend Fund (DLS) is one of the larger foreign-stock funds, with more than $400 million in assets.
Morningstar's Kay said outside of bonds, investors searching for yield may also want to take a look at ETFs for preferred securities and utilities companies. The largest utilities ETF is Utilities Select Sector SPDR Fund (XLU), which holds over $3 billion. Its dividend yield tops 4%, according to State Street.
Preferred-stock ETFs include iShares S&P U.S. Preferred Stock Index Fund (PFF), PowerShares Preferred Portfolio (PGX) and SPDR Wells Fargo Preferred Stock ETF (PSK).
The iShares ETF, which is the largest, with more than $4 billion in assets, is an option for investors "who are looking for a little extra fixed-income yield and are willing to take on the risks imbedded in moving down the capital structure from debt to do so," Morningstar said in its latest profile of the fund.
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