Dividend ETFs See Performance Diverge on Sector Allocations

Includes: DES, DVY, FDL, SDY, VIG
by: John Spence

Investors have been flocking to dividend exchange traded funds, but the performance of these income-themed ETFs can vary from product to product based on the index’s strategy, sector allocations and other factors.

“Dividend paying stocks are supposed to be the ‘easy button’ of investing at the moment,” says ConvergEx Group Chief Market Strategist Nicholas Colas, who counts 35 dividend ETFs.

Low bond yields are one reason behind the popularity of dividend strategies, and Colas notes dividends have historically represented between 25% and 33% of the total return for U.S. stocks.

“Now, we’re talking about those 100 year time series you see quoted in studies on the importance of dividends, but it is a useful point nonetheless,” he wrote in a report Friday. “Dividends are an important portion of total return.”

The three largest dividend ETFs by assets are Vanguard Dividend Appreciation ETF (NYSEARCA:VIG), iShares Dow Jones Select Dividend Index Fund (NYSEARCA:DVY) and SPDR S&P Dividend ETF (NYSEARCA:SDY).

Dividend ETFs can show a wide range of performance. For example, First Trust Morningstar Dividend Leaders (NYSEARCA:FDL) is the best year-to-date performer, gaining 1.8%, while WisdomTree SmallCap Dividend (NYSEARCA:DES) is the worst with a 16.5% loss, says Colas.

The strategist added the spread is “dramatic” but largely due to the performance gap between large and small-cap stocks, and sector allocations. Successful dividend-based investing “seems not so much to be about high payouts as it is about dead-certain ones,” he wrote.

Within the 35 dividend ETFs, there are 13 funds that focus on U.S. equities and they hold over $24 billion in assets. There are 18 developed markets international ETFs with $3.8 billion, and four emerging market dividend ETFs with $2.3 billion, according to ConvergEx.

Colas notes iShares Dow Jones Select Dividend is the best performer in 2011 among the largest dividend ETFs, losing much less than the other two. He attributes this to its large 37% weighting in the utilities sector, which is the best-performing sector among the major groups in the S&P 500.

“This also allows the fund to have one of the highest dividend yields – 3.75% – of the domestic funds we analyzed,” the strategist wrote.

The differences among dividend ETFs highlights the need for research before jumping into a fund. Sector allocations can have a big impact.

For example, in the energy sector there are “plenty of high-yielding names” but energy ETFs are down sharply this year.

“The volatility in energy commodity prices seems to put a question mark on oil company payouts, and those dividends get a discount to the more-certain income stream of utilities,” Colas said.

“Why the dividend exists matters more than any other single factor. I think that is why utilities have been such a great sector this year,” he wrote. “Those equities represent some of the best bond substitute available to most investors, since they provide an essential service and their business models therefore have very little risk.”

iShares Dow Jones Select Dividend

Click to enlarge


Disclosure: Tom Lydon’s clients own DVY.