Investors who are looking for yield have no lack of options these days. The fund industry is tripping over itself to provide vehicles that invest in high-dividend stocks, bringing the total of yield-oriented exchange-traded funds from 29 at the beginning of last year to 49 now. While the importance — and popularity — of dividends has been well-documented, yield-hungry investors also need to be aware of the substantial differences among the domestic dividend ETFs.
Each ETF is designed to track a different underlying index, and these indices, in turn, have divergent selection methodologies and screening criteria. As a result, the underlying portfolios are very diverse, even though they all fall under the “dividend” umbrella. A look at the historical returns of the most popular funds in the space reveals a large dispersion of results:
|Vanguard Dividend Appreciation ETF||VIG||25.56%||13.37%||3.13%|
|iShares Dow Jones Select Dividend Index Fund||DVY||29.83%||17.48%||0.17%|
|SPDR S&P Dividend ETF||SDY||26.23%||13.86%||2.47%|
|Vanguard High Dividend Yield ETF||VYM||31.71%||15.40%||1.94%|
|iShares High Dividend Equity Fund||HDY||34.75%||n/a||n/a|
|PowerShares High Yield Equity Dividend Achievers Portfolio||PEY||27.86%||14.42%||-4.26%|
|PowerShares Exchange Traded Fund Trust Dividend Achievers Portfolio||PFM||27.56%||14.85%||1.22%|
|SPDR S&P 500 ETF
|Total returns through Aug. 10, 2012|
A closer look at these ETFs reveals that the different composition of their associated indices has led to substantial variations in their sector weightings, which in turn has helped fuel the substantial disparities in their long-term returns.
Take the iShares Dow Jones Select Dividend Index Fund (NYSE:DVY). This popular ETF has outperformed both the broader market and Vanguard Dividend Appreciation ETF (NYSE:VIG) by a wide margin in the one- and three-year periods, but it is far behind on the five-year. There are two important reasons for this.
First, DVY has a much larger weighting in utilities than VIG (32% vs. 1%), which has enabled the fund to capitalize on the sector’s massive outperformance in recent years. However, DVY also had a larger weighting in financials coming into the crisis period, and this accounts for its substantial shortfall on the five-year time frame. The same is true for PowerShares High Yield Equity Dividend Achievers Portfolio (NYSE:PEY), which helps explain its massive underperformance in the five-year period.
As a result, selecting one dividend ETF over another is also making a tacit sector bet. By owning DVY, for example, you’re not just investing in dividend stocks — you’re also making a wager on utilities. HDV holds more than a quarter of its portfolio in health care, while VIG and PEY hold similar overweights in industrials and financials, respectively.
Thus, investors must look past the headline results and drill down to see how these funds are actually built, then decide whether the underlying portfolios are attractive.
With that in mind, this table provides a one-stop look at the sector allocations of the major domestic dividend ETFs:
||Cons. Def.||Health Care||Energy||Indus.|
|Materials and technology were omitted since the differences were too minor to have a significant impact|
A second factor in the divergent performance is the nature of the screens used by the underlying indices. VIG, for example, tracks the Dividend Achievers Select Index, which has a high-quality mega-cap bias due to its focus on dividend growth. This is reflected in its two largest holdings: International Business Machines (NYSE:IBM) and Coca Cola (NYSE:KO).
PEY, in contrast, places a greater emphasis on absolute yield. As a result, its top 10 holdings include lower-profile companies such as Vector Group (NYSE:VGR), Pitney Bowes (NYSE:PBI) and insurance provider Mercury General Corp. (NYSE:MCY). As a result, investors also need to be acutely aware of how the market’s swings from a high-quality to low-quality bias will impact their fund. A lower-quality portfolio is likely to underperform in down markets, which isn’t what most dividend-oriented investors expect.
The Bottom Line
Dividend-paying stocks might outperform the market over time, but the differences in the dividend ETFs’ underlying holdings might mute this positive impact in the short term if the underlying sector and/or quality tilts don’t work out. Thus, those in the market for a high-dividend ETF might want to consider diversifying among two or more of these funds to neutralize the idiosyncrasies of each individual portfolio.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.