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Separating the Music From the Noise

The growth of the dividend ETF space appears to be maturing with about 50 plus fund choices as of this writing. Even with several product closings and some more late arrivals (especially the "dividend growth variety") - the current quantity available seems to be more than enough to satisfy most investors' thirst for yield.

The advantage went to the early arrivals in this space. These "first mover advantage" ETFs are quite large by market cap. The first mover advantage for the dividend ETF space with the longest history would include the popular iShares Dow Jones Select Dividend Index Fund (NYSEARCA:DVY), which commenced trading in 2003, and the First Trust Value Line Dividend Index Fund (NYSEARCA:FVD) also started in 2003; actually preceding DVY by a few months. The deluge then followed. Some of the funds available can be quite small. These smaller, lesser known dividend ETFs are usually narrowly focused geographically, strategically, or are very new and have not caught on with investors yet.

When selecting a dividend ETF an investor should know what his goals are and have some realistic expectations in the context of a diversified investment plan. This article seeks to touch on some selection considerations and criteria that I think is important in the very large dividend ETF sub category.

Advantages and General Considerations for Dividend ETFs:

Diversification

The dividend ETF space can offer some diversification while providing some desired equity yield. There are many domestic U.S. centric equity dividend funds with many methodologies. These domestic large cap dividend ETFs are among the most popular available. The niche for emerging market dividend ETFs have also gained a tremendous amount of popularity the last few years. Some examples of this sub category of dividend ETFs include WisdomTree Emerging Market Equity Income Fund (NYSEARCA:DEM), and SPDR S&P Emerging Markets Dividend Fund (NYSEARCA:EDIV).

Globally themed dividend ETFs as well as international dividend ETFs have also gained steam in the dividend ETF category. The main difference being that the global varieties include U.S. holdings, where the international dividend ETFs exclude U.S. holdings (often called "ex-U.S." type funds). Examples of two popular global and international dividend ETFs are First Trust Dow Jones Global Select Dividend Index Fund (NYSEARCA:FGD) and PowerShares International Dividend Achievers Portfolio (NYSEARCA:PID).

WisdomTree offers a multitude of dividend ETFs including the style variety for Large, Mid and Small cap domestic dividend ETFs. DLN is a popular example of their large cap dividend offering. They also go even further by offering some international style flavors for dividend ETFs such as WisdomTree International Large Cap Dividend Fund (NYSEARCA:DOL).

Liquidity

The larger the ETF has in market cap, the more liquid. The smaller in market cap, the less liquid the fund is and may be difficult to get in and out of. I prefer to express this in market cap versus assets under management - AUM. AUM is for those folks who charge investors fees and seek to grow assets (grow fees) - not an individual investor's job to worry about in that context. The fund's market cap and AUM are actually very close in magnitude and equivalence anyway.

The underlying assets of an ETF will determine its liquidity and impacts the bid ask spread. This is especially true of ETFs holding small cap companies or foreign stocks. If an ETF holds lots of illiquid high yield small caps or exotic foreign stocks, that ETF may have a higher bid ask spread. Always use limit orders and read the fact sheets and the prospectus to find the NAV symbol for that fund.

Depending on liquidity of the fund and its underlying holdings, an investor can see how close the bid ask spread is - as well as the spread to its NAV by comparing the market quote to the NAV or intraday indicative value quote. An obscure fund with unusual holdings is used here as an example. NAV quote: (GULF) link.

Convenience

The convenience factor can be desirable and is usually what attracts investors to ETFs to begin with. Many investors prefer holding a basket of (in this case) higher yielding dividend stocks than holding individual stocks. Properly researching individual issues may not appeal to all investors. This can be quite time consuming and the due diligence required researching a company's dividend history, dividend quality, payout ratios, earnings, growth prospects, risk metrics, etc., can be daunting.

Many investors may not want to invest the time required for this due diligence and prefer a pre-made basket that is based on an index. They may prefer spending that time on other pursuits such as time with grand kids, family, school, or some other activity. They may not want to baby-sit and periodically re-balance those 20 or so stocks in a portfolio. On the other hand, some investors enjoy the intellectual challenge, the research, the proxies, reading the 10-K's, earnings drama anticipation, press releases, etc.

Another major benefit is that it's much easier to hold a high yield foreign stock in an international or global dividend ETF than buying those stocks individually here in the U.S. Those kinds of issues are likely not listed here (as an ADR or GDR) on our domestic exchanges. Who wants that headache and expense?

Practical Criteria and Considerations for Dividend ETFs:

Yield

Obviously one of the main attractions of a dividend ETF is yield. Especially in the context of our low yield world due to Fed market intervention and other global market policies. Dividend ETFs have many different approaches for stock inclusion in their index - including high yield stocks. It's important to note that in any asset class the higher the yield, the higher the risk. Recently the Fed has been sending signals that the loose money policy will eventually end. All of the "safe haven" and "boring," dividend yielding stocks have temporarily gone out of favor. These policy upheavals are generally unsettling and uncomfortable to investors but ultimately often prove to be buying opportunities. Some examples of ETFs with emphasis on high yield include Global X SuperDividend ETF (NYSEARCA:SDIV) and Vanguard High Dividend Yield ETF (NYSEARCA:VYM).

The all Important Index

The index a dividend ETF tracks has always been a very important consideration for a selection process. How long has the index been in existence? Is there a large tracking error to the fund's NAV? Can I back-test the index? Is this back-testing data available? These questions may take a bit of digging but in my opinion is an essential exercise in researching any index based fund. Some of the information sought can sometimes be found in the ETF's fact sheet and/or the prospectus. You can then often find some information for the index methodology and selection process. Many of these indexes are from familiar or established index providers such as Dow Jones, Standard and Poor's, MSCI, Russell, FTSE, Morningstar, and many others. There are also some boutique, lesser-known indexes and even some that are internally designed - from the funds sponsor. Examples of these are EGShares Low Volatility Emerging Markets Dividend ETF (NYSEARCA:HILO) and FlexShares Quality Dividend Index Fund (NYSEARCA:QDF) respectively. Examine the methodology for a ETFs index carefully (if possible).

Portfolio

During the financial crisis the dividend ETFs that were heavily weighted with financial sector holdings did very poorly. A heavy weighting or under weighting to a specific sector can have a great influence on a fund's performance. Some ETFs have a safety or volatility bias in their stock inclusions such as the iShares High Dividend ETF (NYSEARCA:HDV) or PowerShares S&P 500 High Dividend Portfolio ETF (NYSEARCA:SPHD). These funds take dividend quality factors and/or volatility into consideration for their strategy.

Note that "safety" can be a relative and fleeting term in a changing interest rate environment. One fund that casts aside any sector concentration concerns is the equally weighted ALPS Sector Dividend Dogs ETF (NYSEARCA:SDOG). This ETF with a contrarian bet simply equally weights all ten sectors with five of the highest yielding S&P 500 stocks for each sector.

Dividend History

Investors can review a fund's dividend history either on the sponsor's web page for that fund or other places such as NASDAQ's site or Yahoo Finance. It can be an interesting and revealing exercise to review a dividend ETF's dividend history, especially during the bear market of late 2008 and early 2009. As Warren Buffett says "Only when the tide goes out do you discover who's been swimming naked." The naked dividend ETF swimmers in that bear market were typically overweight the financial sector.

Does the Fund Emphasize Dividend Growth, Income, Total Return?

Dividend growth or total return, monthly income? A total return or for others an income approach is an important consideration for investors. Older investors typically seek efficient and stable dividend income versus total return or dividend growth because they may wish to use that dividend income for monthly living expenses. On the other hand younger investors with a long-term investing horizon usually wish to see that nest egg grow in total return - with rising dividends, and capital appreciation both adding to the kitty.

These considerations are where yield and dividend frequency may come into play. A high yielding fund with maybe a monthly payout versus quarterly may be desirable for some income investors while the total return aspect - a much less important factor. Some dividend ETFs that pay monthly are PowerShares High Yield Equity Dividend Achievers (NYSEARCA:PEY) and multiple funds from WisdomTree.

Expenses

Fees for a typical dividend ETF run the gambit from very thrifty products such as the domestic centric Schwab U.S. Dividend Equity ETF (NYSEARCA:SCHD) charging just 7 basis points (O.07%) - to some pricey fees of 0.85% for the previously mentioned EGShares Low Volatility Emerging Markets Dividend ETF. FINRA has a handy tool that calculates the impact of fees and expenses over time. Remember that cheaper is not always necessarily better, and pricey may not be worth it. Investors should consider fees in the context of performance, investment horizon, and personal choice.

Performance

"It is my feeling that Time ripens all things; with Time all things are revealed; Time is the father of truth." -François Rabelais

Below is a five-year total return chart for some popular and established dividend ETFs:

(freerealtime.com)

(click to enlarge)

Outperformance can be relative and fleeting, and can sometimes be the quiet ugly duckling in the corner that takes home the ribbons.

Putting it all together:

  1. Examine the fact-sheets.
  2. Read the prospectuses.
  3. Research the index the product is based on (if possible).
  4. Examine volume and liquidity - use limit orders. Is it viable?
  5. Consider how it fits in a portfolio.
  6. Should you use more than one?
  7. Be aware of risks from rising rates.
  8. Be mindful of duplication from your other holdings in a portfolio.
  9. Consider sector concentration resulting in risk/opportunity.
  10. Fees and expenses should always be considered.
Source: Sorting Out The Crowded Dividend ETF Parade