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Dividend ETFs have been at the intersection of two of the hottest investing trends over the last year or so, turning in stellar performances and attracting huge cash inflows. Interest in dividend-paying stocks has skyrocketed, as these securities have double-edged appeal as tools for both smoothing overall volatility and enhancing the current returns derived from equity portfolios. In an environment with several large risks continuing to loom overhead and depressed interest rates, that combination is tough to beat. Not surprisingly, ETFs have become a preferred vehicle for accessing dividend-focused strategies; there are now more than 45 dividend ETFs accessible to U.S. investors, with aggregate assets of more than $40 billion [see Premium Report: Dividend ETFs In Focus].

Dividend ETFs have turned in some impressive performance figures over the past 14 months or so; since the start of 2011, the WisdomTree Large Cap Dividend Fund (DLN) has beaten the S&P 500 SPDR (SPY) by nearly 500 basis points. That margin is particularly impressive considering that stocks have generally been up over that period, and dividend payers should presumably be “safer” investments.

Despite the recent success, dividend ETFs could be setting investors up for a colossal disappointment. As Meb Faber pointed out in a post last month, dividends could be squarely in the crosshairs of a proposal being tossed about Washington. A recent budget proposal from the Obama administration includes a significantly higher tax on dividends, essentially taxing payouts from companies as ordinary income. That translates to a jump from a flat rate of about 15% now to nearly 40% for Americans in the top tax bracket. It’s estimated that the change would raise more than $200 billion over ten years, helping to close the widening budget deficit.

Dividend ETFs In Danger?

Faber’s analysis of this potential development focused on the impact this legislation would have on companies–specifically, that they would continue to reduce dividend payments in favor of stock buybacks in order to maximize after tax returns delivered to shareholders. When the tax rate on capital gains is lower than the tax rate on dividends, it is logical to conclude that most investors will prefer capital gains.

But there is another potential ramification of this element of the most recent budget proposal; a spike in the taxes on dividends would make the securities that deliver a significant portion of their returns through distributions less appealing to investors. Relative to securities that rely on capital appreciation (i.e., the non-dividend payers), dividend stocks would lose a bit of their luster [see ETF Tax Tutorial]. Just as the drastic cut on dividend tax rates in the early 2000s gave a boost to dividend-paying stocks, the reversal of this policy would deal them a one-time body blow. The proposed tax hike would likely reverse the tremendous interest in this asset class that has built up in recent years, and cause investors to lose a significant portion of their dividend appetite.

Dividend ETFs To Watch

Given the gridlock that has gripped Washington over the last couple years, a jump in the dividend tax rate is certainly not a done deal–far from it. But it remains a possibility in an election year where anything can happen and outrage sparked by the low effective tax rates incurred by the Mitt Romneys and Warren Buffetts of the world is escalating. It’s also worth noting that the proposed hike on dividend tax rates wouldn’t be unprecedented–in fact, it was the norm until the Bush tax cuts went into effect in 2002 (those in the top tax bracket paid a top tax rate of 35% of dividends).

There are about four dozen ETFs that focus on dividend-paying companies, including some that value consistency of dividends and others that zero in on the most attractive dividend yields [see 12 High Yielding Commodities]. A few of the more popular dividend ETFs that could be impacted by any changes to tax policy include:

  • Vanguard Dividend Appreciation ETF (VIG): This ETF focuses on companies that have steadily increased their dividend; the portfolio includes companies that have recorded dividend increases for at least ten consecutive years, including stocks like McDonald’s, IBM, and Coca-Cola.
  • iShares Dow Jones Select Dividend Index Fund (DVY): This ETF is linked to an index that consists of about 100 high-yielding stocks; the underlying benchmark screens potential components by dividend growth rate, dividend payout percentage, and average daily trading volume.
  • SPDR S&P Dividend ETF (SDY): This ETF is linked to the S&P High Yield Dividend Aristocrats Index, a benchmark that includes companies that have increased dividends for at least 25 consecutive years. Pitney Bowes ant Cincinnati Financial Corp., and AT&T are among the largest individual allocations in this ETF.
  • Vanguard High Yield Dividend ETF (VYM): This ETF includes the non-REIT stocks with the highest dividend yields; currently, top components include Exxon, Microsoft, and Chevron.

Disclosure: No positions at time of writing.

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Source: Tax Reform And Dividend ETFs: Cause For Concern?