Dividend ETFs: Yield, Quality or Both?

When choosing ETFs, it's not always about the best yield

In the income investing universe, participants have a predisposition to focusing on ETFs with the highest headline yields. After all, income investors have a way of keying in on a yield that matches up with their spendable cash flow needs.

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Yet more recently, there are a myriad of so-called “dividend growth ETFs” that sport yields just slightly higher than blended indexes, such as the S&P 500.

So what gives and how can these two income styles be commingled?

In my opinion, dividend investors have realized that it’s not all about the yield and to fashion a well-diversified portfolio they are going to need to straddle the lines a bit. The key differentiator that these new breed of income funds bring to the table is the concept of intermingling quality holdings with successful long-term dividend stories.

Traditional high-yield indexes such as the iShares Select Dividend ETF (NYSEARCA:DVY) or PowerShares S&P 500 High Dividend Portfolio (NYSEARCA:SPHD) are constructed by selecting the top-paying stocks within a broad equity universe. The end result is a concentrated portfolio of companies with an aggregate dividend stream in the neighborhood of 3% to 3.5%.

Focusing on high-dividend stocks alone in your portfolio often leads to bloated valuations, lopsided sector allocations and uncertain opportunities for capital appreciation. Furthermore, there isn’t any guarantee that they will exhibit less volatility than the broad market.

As a result, relatively conservative investors are left to grit their teeth in hopes the income is enough to overcome the inevitable cyclical challenges along the way.

In addition, if interest rates rise, your high-dividend stocks will be forced to compete with more attractive yields in bonds. So you could ultimately find yourself stuck holding the bag as other investors rush for the exits in favor of lower volatility fixed income.

If that explanation came across sounding like a one-sided approach to investing; that’s because it is.

To overcome this structural flaw, savvy income investors have been adding funds such as the Vanguard Dividend Appreciation Fund (NYSEARCA:VIG) or WisdomTree U.S. Dividend Growth ETF (NASDAQ:DGRW) to their portfolios in search of capital appreciation and to catch the next wave of emerging large-cap dividend stocks.

The dividend growth theme has offered investors a new facet to income investing: companies that are committed to paying and growing their dividends, but just as concerned with growing top- and bottom-line earnings. Both ETFs currently sport yields near 2%.

When compared with the aforementioned high-dividend stock indexes such as DVY or SPHD, the dividend growth funds average a 40% reduction in yield. However, they fill the “holes” in a high-dividend-only approach with larger allocations to technology, consumer discretionary and industrial stocks.

For example, Apple Inc. (NASDAQ:AAPL) is the second-largest holding in DGRW, yet is nowhere to be found in DVY or SPHD for lack of not ranking in the top percentage of dividend payers in Dow Jones Industrial Average and S&P indexes.

While stalwart dividend stocks are likely to remain a pillar of familiarity in many investors’ portfolios, I encourage you to broaden your dividend horizons so that you’re able to keep pace with an ever-changing world. Besides, if you focus on total return — or the sum of capital appreciation and income — it shouldn’t matter at the end of the year how you ultimately reached your goals.

David Fabian is Managing Partner and Chief Operations Officer of FMD Capital Management. As of this writing, clients of FMD Capital owned VIG. To get more investor insights from FMD Capital, visit their blog.

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