2012 was not a great year for dividend ETFs, as many investors avoided them in the last quarter of the year due to risk of a huge increase in taxes. Fortunately, the agreement on dividend taxes was more favorable than expected and thus dividend ETFs should regain their appeal and popularity this year.
Dividend taxes for top-bracket taxpayers will rise from 15% to 20% (plus an additional 3.8% surcharge for Obamacare), while the taxes for those in the lower tax brackets would remain at the current levels. (For more, read "Three Great ETFs to Buy This Earnings Season.")
Per S&P Dow Jones, companies in the S&P 500 index paid out regular cash dividends of $281 billion in 2012 -- 17% higher than 2011 and 13% more than the previous record in 2008 -- without counting all the dividends that companies might have paid in January, but paid in 2012 in order to avoid higher taxes in 2013. S&P expects 2013 to be another record year for dividend payments, after the cliff resolution.
Most large U.S. corporations are sitting on large cash piles and are in a position to increase payouts to the shareholders. Further, there would be no difference between tax rates on long-term capital gains and dividends. In case the dividend taxes had increased more than the taxes on capital gains, many companies would have increased share buybacks and reduced dividend payouts. (For more, read " Best ETF Strategies for 2013.")
Also, dividend stocks and ETFs are much better options for yield-hungry investors in this environment of ultra-low rates. Many investors continued to seek refuge in so-called "safe haven" assets last year as the markets stayed volatile due to uncertain situation in Europe, slowing growth in the emerging markets and fiscal cliff in the U.S. Furthermore, as the Fed continued its massive asset purchases, Treasury yields plunged to new lows.
However, the situation is likely to change this year. The Federal Reserve may slow down or end its bond purchases in 2013, and the interest rates may start going up. At current yield levels, the losses will be very high when the rates go up and thus it would be best for the individual investors to stay away from Treasury bonds now. (For more, read "Time to Exit Treasury Bond ETFs.")
At the same time, since most dividend paying companies are stable, mature companies, these investments also provide greater stability and safety in a volatile environment. And the markets are expected to experience higher volatility if the debt ceiling negotiations turn ugly or if the eurozone situation worsens.
We prefer the ETFs that invest in stable, cash-rich, low-risk companies that have solid growth potential, compared with the ETFs that focus just on the yield. Below we present four such ETFs that provide a stable stream of income to the investors and provide stability to the portfolio.
Vanguard Dividend Appreciation ETF (NYSEARCA:VIG)
VIG follows the Dividend Achievers Select Index, which is composed of common stocks of high quality companies that have a record of increasing dividends for at least 10 years. Launched in April 2006, the fund is now the largest dividend ETF, with $12.7 billion in AUM.
The fund is currently home to 133 securities, with a median market cap of about $40 billion. Wal-Mart (NYSE:WMT), Coca-Cola (NYSE:KO), and Procter & Gamble (NYSE:PG) are the top three holdings, while the top 10 largest holdings account for 37.5% of the assets. The ETF is heavily weighted toward Consumer Discretionary (15%), Consumer Staples (24%), and Energy (10%) sectors.
With an expense ratio of 0.13%, this is one of the cheapest funds in this space. The dividend yield at 2.26% is just slightly above average S&P dividend yield, but this fund is better suited for investors who seek long-term capital appreciation along with income and not just high current yield. The fund has a beta of 0.82 vs. the S&P 500.
SPDR S&P Dividend ETF (NYSEARCA:SDY)
Launched in November 2005, this fund is based on the S&P High Yield Dividend Aristocrats Index. It is designed to track the performance of highest dividend yielding companies within the S&P Composite 1500 Index companies, which have been consistently increasing their dividends every year for at least 20 years.
In terms of sector exposure, the fund focuses on Consumer Staples (21%), Industrials (16%), and Financials (15%). The fund holds 83 securities and is very well-diversified, with the top holding accounting for just 2.9% of total assets. With an expense ratio of 35 basis points, this fund is more expensive than VIG but has an attractive yield of 3.13% currently.
PowerShares S&P 500 High Dividend Portfolio (NYSEARCA:SPHD)
SPHD intends to combine two most desirable investment themes -- high dividend and low volatility, which almost guarantees the long-term success of this ETF. The index is composed of 50 stocks that historically have provided high dividend yields and exhibited low volatility.
The ETF is heavily weighted towards Consumer Staples (17%), Financials (14%), and Telecom (10%) sectors. Launched in October last year, the fund has attracted more than $41 million in assets so far. It charges an expense ratio of 30 basis points and currently has an excellent distribution yield of 4.27%.
EGShares Low Volatility EM Dividend ETF (NYSEARCA:HILO)
HILO is an ideal option for investors seeking to benefit from high dividend yield and high growth potential of the emerging market companies, while trying to avoid excess volatility associated with some such companies. HILO tracks INDXX Emerging Market High Income Low Beta Index, designed to provide high income and to be significantly less volatile through the utilization of low beta stocks. The index has a beta of 0.94 vs. MSCI EAFE Index. Further, the Index limits concentration in any position to 5% and country exposure to a maximum of five positions.
South Africa (21.4%), Turkey (16.1%), and India (11.4%) occupy the top spots in terms of country exposure. The fund holds 30 securities with an average market cap of about $14 billion. The ETF is tilted toward Financials (21%), Consumer Goods (18%), and Telecom (17%) sectors. The fund has an expense ratio of 85 basis points and currently yields 4.96%.