How To Reduce Risk With Dividend ETFs

 |  Includes: DLN, SDY
by: Tom Lydon

Investors can lower risk in their stock portfolios with dividend ETFs, but they should keep in mind the equity-based funds shouldn't be substituted for bonds.

When playing the income game, exchange traded fund investors have been increasingly reaching for yields.

According to fund tracker EPFR Global, investors funneled $34 billion into dividend stock funds so far this year, The Wall Street Journal reports. With the 1.60% yield in the 10-year Treasury market and the 2.3% yield in the S&P 500, investors have turned to dividend picks as a way to generate more income.

However, investors should not confuse dividend stocks with fixed-income assets, especially during volatile market conditions. For instance, in the third quarter of 2011, the WisdomTree LargeCap Dividend ETF (NYSEARCA:DLN) dropped 9.7%, while the Barclays U.S. Aggregate Bond Index rose 3.8%.

Moreover, Owen Murray, director of investments at Horizon Advisors, warns that investors should not be overexposed to the highest-yielding stocks -- high payments usually indicate that the company is in trouble or the yield is unsustainable.

"You have to reach for yield, but some investors are taking it too far," Jason Thomas, chief investment officer at Aspiriant, said in the WSJ article.

Instead, Aaron Gurwitz, chief investment officer of Barclays's wealth and investment-management division, suggests to allocate a portion of an income portfolio to dividends. For instance, a risk-tolerant investor may take on 65% to 70% in dividend stocks, whereas the more conservative investors would keep equities positions below 20%.

Moreover, investors can also strengthen their dividend position through focusing on quality companies that have a history of boosting payments. For example, the SPDR S&P Dividend ETF (NYSEARCA:SDY) follows companies of the S&P 1500 that have increased dividends for the last 25 consecutive years. SDY has a yield of 3.2%.

Max Chen contributed to this article.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.