The Exchange Traded Funds (ETF) industry has ballooned since 1993, when the first ETF on S&P 500 was introduced. Currently, there are hundreds of ETF’s covering many investment strategies present. One strategy which is also being covered with dividend etf’s includes dividend paying stocks. In this article I would discuss the positives and negatives of dividend ETF’s, and explain why they are bad for income investors.
Some of the positives of owning dividend ETFs include instant diversification, ability to invest passively and the ability to gain exposure if you do not have a lot of money.
1) Instant diversification,
The biggest allure of dividend ETF’s is the fact that investors can easily purchase a basket of shares with just one trade. This basket of shares would be representative of different industries included in the index, and would reduce the risk that our investor overcommits to a certain sector if they are prone to chasing yield for example. Plus, you get to pay one commission to purchase a whole basket of stocks, or some companies might let you purchase ETF's commission free.
2) Ability to invest passively
Another appeal of dividend ETF’s is that it lets investors purchase a basket of stocks, and then not have to worry about analyzing stocks, monitoring 30 - 40 companies in detail. This is the job of the investment manager in charge of the ETF, who reads annual reports, keeps up with current environment, calls companies and does all the leg work so that the investor does not have to do it. Reading annual reports could sometimes be an intimidating or very boring task for some investors. The dividend ETF is ideal for investors who want to set the investment, and forget it.
3) Good for beginning investors who are still learning and have less than $10,000
The investment in a dividend ETF or dividend mutual fund is probably best for beginning investors who have less than $10,000 to start with. It offers them instant diversification and passive investment at the fraction of the cost of a do-it-yourself portfolio using an online broker. Dividend ETF’s also make it very easy for investors to put additional funds to work, while maintaining sector diversification in the index and without worrying which of the 30 - 40 securities is the best one to buy.
1) Annual costs
While Dividend ETF’s provide investors with instant diversification and the ability to let someone else to worry about the mundane details, the Ivy League investment manager comes at a price. In addition, most companies that offer dividend ETF’s also want to earn a fair profit on this product. As a result, investors in some of the largest dividend ETF’s like SPDR S&P Dividend (SDY) and iShares Dow Jones Select Dividend Index (DVY) pay 0.35% – 0.40% per year in management costs. If the stock portfolios in those ETF's yield 3% on average, this means that 12%-13% of your dividend income will be paid out as an investment tax. If our investor is also in the top bracket, and pays 23.80% federal tax on the income, they would end up with only two-thirds of their desired dividend income. While placing your stocks in a tax-deferred account such as a Roth IRA can eliminate taxation issues, placing your investments in ETF’s would result in recurring annual charges. In fact, investment companies end up charging their fees on a daily basis. This compounding of fees could cost investors large amounts of money over a normal 20 - 30 year investment period. While many ETF’s are now commission free at various brokerage houses, investors would need to pay a commission for most of the dividend ETF’s out there.
2) Investors have no say about which stocks the ETF holds
Another negative of dividend ETF’s is that investors have no say on how these baskets of stocks should be invested. Sometimes, a dividend ETF might hold shares that do not fit in its strategy for months. For example, back in 2008 and 2009, the SPDR S&P Dividend ETF (SDY) held on to shares of companies that cut or eliminated distributions for several months after the fact. As a result, a portion of the capital of this ETF was not properly invested and was not generating much in dividend income for investors. In addition, many dividend ETF’s are placing higher weights on higher yielding stocks, which could increase risk for income investors. This increases exposure to companies with accidental high yields which are large because the dividend is in danger. In addition, some of these ETF’s also tend to focus mostly on higher yielding sectors like utilities and financials, which could increase risk as the portfolios would not be properly diversified.
3) Investors fail to learn about investing
The most successful investors make their own investments, after a careful analysis. If investors simply purchase an ETF, they might not truly get an understanding of what they are buying and could pay a high price over time. Educating yourself on how companies make money, how the economy works and understanding how to value a security would be beneficial to investors who follow stocks, bonds, commodities or real estate. If they blindly buy ETF’s or mutual funds without fully understanding what they are getting into, they might be much more likely to lose money by selling out during bear markets or by getting overly excited about the wrong investments at the most inopportune times.
4) If not enough money is attracted, the ETF could be closed
Another less known risk about dividend ETF’s is that if the fund fails to attract enough investors, it could end up closing and returning money to investors. If our investor is passive and only checks their portfolio once or twice/year, this could mean that they can potentially miss on potential upside by not being invested in the markets. A small ETF size typically also translates into higher bid/ask spreads and higher annual costs.
5) Too much turnover
I am a pretty passive dividend investor, who makes sell transactions very rarely. In fact, I have realized that one of my largest mistakes I have committed in the past few years was selling fine companies in order to get something that I thought is better. The end result of this mistake is that I have ended up with more paperwork, and transaction costs, without really achieving a better benefit. Talk about reinvestment risk. Therefore, I am not a fan of ETFs or Mutual funds that have turnover, which produces capital gains that investors have to foot the bill for, without really getting anything extra. The issue with dividend ETFs is that they contain quite a lot of turnover, and unfortunately the investor does not have any say about it. Honestly, if a company I own froze dividends for a few years, it would not be a strong enough sell signal for me. I also don't want to sell a company when it splits into two after raising dividends for 40 years, despite the fact that the new companies lack a record of dividend increases. This happened with Altria (MO) after it spun-off Kraft (KRFT) and Phillip Morris International (PM) in 2007 and 2008.
With ETFs, investors have no say over the valuations at which companies are purchased or added. For example, a dividend ETF portfolio could include stocks which are ridiculously overvalued and selling at 30 - 40 times earnings. Even the best dividend stock is not worth overpaying for, since paying too much could potentially lower investors returns (dividend income and total returns). When you purchase a dividend ETF/dividend mutual fun, you end up buying stocks regardless of their valuation, which could be detrimental to long-term results. As an individual stock picker, I carefully weigh valuation and prospects before purchasing a security for my own individual portfolio.
7) Concentration Risk
For many dividend ETF's, you usually have the top 10 holdings account for a significant chunk of the portfolio. This is because those funds tend to weight portfolios based on market capitalization, rather than sensible investment criteria such as valuation, safety of dividend and stock analysis. For some dividend ETFs, the top 10 holdings have accounted for over 45% of portfolio value. This creates too much unnecessary risk for the portfolio, since a failure will be felt much more if it comes from one or two of the top ten holdings, than from one or two of the lower weighted ones. In my portfolio, I usually strive for equal weighting.
For my personal portfolio, I tend to invest in stocks directly, and build my exposure to different sectors from the ground up. I have a direct say on portfolio weights, and selecting only companies whose stocks are attractively priced at the moment. My only cost is the commission to buy or sell securities. If commissions were $5/trade, an investors purchased shares in $1000 increments, then this comes out to a 0.50% one-time cost. This is a much better cost than paying 0.35% – 0.40% every year. During a 20 - 30 year period the costs are going to reduce income over time. In addition, I have flexibility to exit stocks that do not make sense right away, and reinvesting the funds into another security that makes sense. Plus, if you achieve a certain net worth, your investment costs might be close to nill with some brokerage houses.
Full Disclosure: Long MO, PM, MDLZ, KRFT,
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Friday, April 18, 2014
Wednesday, July 7, 2010
Dividends have historically contributed about 40% of common stocks annual average returns. Reinvested dividends however have contributed almost 97% of S&P 500 total returns since 1871. Add to that the fact that retirees are looking for a better way to generate income than the low rates on bank deposits. Thus it is no surprise that investors’ interest in dividend investing is increasing.
Two differing paths are presented to aspiring dividend investors. One path is to do it on your own. Another path is to trust the experience of an investment professional and invest in dividend funds or dividend etfs. In this article I would compare and contrast the two methods and also outline some of the most widely held alternatives for both scenarios.
The main advantages of dividend funds are the instant diversification that investors achieve, since many of them hold a large basket of securities. It might also be cheaper to purchase one ETF than purchasing 30 or 40 individual securities.
Another advantage of holding dividend etf’s is the time saved in research or portfolio rebalancing. This benefit of dividend ETF’s is especially important for busy investors.
One disadvantage of dividend etfs is that they might follow an index or a strategy which is too slow to react to changes in the companies owned. For example, the companies which are members of the S&P High Yield Dividend Aristocrats index (SDY) are added or removed once an year. This means that a company like General Electric (GE), which cut dividends in February 2009 stayed in the index until December 2009. Most income investors would have disposed of the stock immediately after the dividend announcement.
Another disadvantage might be that these dividend indexes could be constructed and ran on autopilot. One recent example is dividend indexes which overweigh companies with a higher yield, without taking into consideration the sustainability of the dividend payment. Because of this many dividend etf’s were overweight financial stocks such as Bank of America (BAC) or Fifth-Third Bank (FITB) before they had cut dividends substantially. This added further pain to the ETF’s already depressed share prices.
A third disadvantage of dividend funds is annual management fees. Because they typically have smaller asset bases, and because they are more actively managed than regular index funds, investors pay between 0.40% for iShares Dow Jones Select Dividend Index ETF (DVY) and 0.60 % for the The PowerShares Dividend Achievers ETF (PFM). This could detract from long-term performance and could prove costly in the long run. Another disadvantage is the fact that investors would be subject to excessive turnover within their etf portfolios. Many indexes such as the dividend achievers for example have a small but consistent turnover which might detract from long term performance.
Another issue with ETF’s is that most of their holdings are concentrated in large cap dividend stocks, which account for a large portion of the movement in the underlying indexes. For example, the ten largest holdings of the Powershares Dividend Achievers ETF (PFM) include:
The ETF currently has 212 holdings. The top 10 holdings account for almost 46% of the total portfolio.
Thus, by purchasing the ETF, dividend investors are being charged an annual management fee, are subject to large annual holdings turnover and essentially hold a portfolio which is not as diversified as it looks initially. If you simply purchased stock in large cap companies such as Wal-Mart (WMT), Procter & Gamble (PG), Johnson & Johnson (JNJ), Chevron-Texaco (CVX), PepsiCo (PEP) and others, investors could benefit from dividend investing, without having to pay fees each year for the privilege of being an income investor.
If instead investors focus on building their portfolios, they could pay little or no commissions, they could adjust portfolio weights any way they want and could invest not only in the large cap stocks but also in small but promising dividend growth stocks.
Full Disclosure: Long PG, T, XOM, CVX, WMT, JNJ,KO,PEP ABT
Wednesday, March 11, 2009
Preferred shares are typically equity with a higher ranking than ordinary shares. Preferred stock does not have voting rights but has a fixed dividend payment, just like a bond. In a bankruptcy or liquidation of the corporation, preferred shareholders have a superior priority over common shareholders, but a lower priority in comparison to bond holders. Preferred stockholders are also first in line to receive dividend payments, which are typically fixed. They don’t typically get to share in the prosperity of the enterprise however as preferred stock dividends do not increase. In tough economic conditions however, preferred stock dividends are much less likely to be cut or suspended; as long as the company continues operating as a going concern preferred stock dividends continue getting paid.
There are several ETF’s, which enable investors to participate in a basket of preferred stocks. One of the most active ETFs is the iShares S&P U.S. Preferred Stock Index (PFF) and the other is Powershares Financial Preferred (PGF). PFF currently yields 10.77% and has an expense ratio of 0.48%. Financials account for over 81% of PFF’s asset allocation, while materials and Health Care account for 8% and 7% respectively.
PGF currently yields 19.90% and has an annual management fee of 0.72%. PGF’s holdings consist only of financial preferred shares. The main difference with PFF is that PGF holds preferred stock in foreign banks such as Credit Suisse, HSBC, Royal Bank of Scotland and ING Group.
Preferred stocks have typically enjoyed above average dividend yields. In addition to that preferred shares have usually come from financial companies. Regulators require banks to have adequate capital to support their liabilities and require that they hold a certain minimum level of Tier 1 capital. Because preferred shares are normally less expensive to issue than common stock, banks issue preferred stocks quite often.
The financial crisis that started in 2007 has affected negatively the market for preferred shares, which have taken a beating. Investors who chased high yielding preferred stock ETFs got burned in the process as well. The iShares S&P U.S. Preferred Stock Index, which lost almost 24% in 2008 are down 45.70% year to date. The Powershares Financial Preferred ETF also lost 27.30% in 2008 and 55.7% so far in 2009.
Main reason why investors are fleeing preferred stocks is the high allocation of financial companies. The bailout of Freddie Mac (FRE) and Fannie Mae (FNM) by the US government resulted in elimination of dividends for preferred shareholders. Most recently Citigroup (C) announced that it would suspend dividends on some preferred shares, which could be a final blow to investors seeking fixed income. Investors are worried that the rest of financial stocks, which received TARP money, such as Bank of America (BAC), Wells Fargo (WFC) and US Bancorp (USB), could be next to cut the dividend payments on their preferred shares.
Because of the current uncertainty in preferred dividends, I do not view PFF and PGF as buys at these levels. Investors who learned the hard way not to chase yield should think twice before diworsifying into preferreds.
- TARP is bad for dividend investors
- Can USB and WFC maintain their current dividends?
- Don’t chase High Yielding Stocks Blindly
- Which Bank will be next? Follow the dividend cuts
Wednesday, January 21, 2009
When investing in index funds, Investors typically focus on the dividend yields on the indexes as a barometer for the whole market. With yields on major US indexes rising above the 10 year Treasury Notes for the first time in over 50 years, dividend stocks look more promising to investors seeking current investment income.
One thing to note however is that not all stocks in major US indexes pay dividends. Only 368 out of 500 stocks in the S&P 500 pay dividends. The average yield on those is 3.73% , which is a full percentage point higher than the yield on the broad market benchmark. (source indexarb). Dow Industrials is the most “dividend friendly” index as 29 out of 30 of its components pay dividends. Furthermore most of the stocks in the Dow Industrials also have had a long history of stable dividend rates or consistent dividend raises. General Motors is the only stock in the Dow Jones that doesn't pay a dividend.
Nasdaq 100 is the tech heavy index which consists of only 31 dividend payers, out of 100 stocks in the index overall. Without the power of dividends, the once high flying index might take much longer to reach its 2000 highs versus the fifteen years that took Dow Industrials to reach its 1929 highs after the Great Depression.
Thursday, November 13, 2008
In my blog, Dividend Growth Investor, I am always trying to find out the best dividend stocks which would provide me with a dividend income stream that would increase above the levels of inflation for many decades to come. If I didn’t have any time to go through all the hassle of picking individual dividend stocks however, I would have turned to dividend ETF’s.
I have stated several reasons why I don’t like investing in dividend etf’s in a previous article. If you want to own a portfolio of stocks which is ready to be purchased in a single ETF trade, and paying an annual fee is not an issue for you, then this article could be beneficial for you.
Most of my readers are aware that I am fascinated with the Dividend Aristocrats index, which is an equally weighted index which includes a select group of dividend stocks which have increased their dividends for over twenty five consecutive years. The bad news is that there isn’t an ETF that covers this index at the time. There is however an dividend ETF which covers the High-Yield Dividend Aristocrats index, which resembles the dividend aristocrats index closely in terms of performance and components.
The S&P High Yield Dividend Aristocrats ETF has an annual fee of 0.35%. The ETF currently yields 4.40%.
There are several other notable dividend ETF’s out there as well, which focus on rising dividend income:
PowerShares HighYield Dividend Achievers ETF (PEY) tracks the Mergent’s Highest Yielding Dividend Achievers Index. The total annual fee is 0.60%, while the index is currently yielding 5.69%.
The PowerShares Dividend Achievers ETF (PFM) tracks The Broad Dividend Achievers Index, which consists of companies that have increased their annual dividend for ten or more consecutive fiscal years. The annual fee is 0.60%, and the current yield is 2.72%.
The PowerShares International Dividend Achievers ETF (PID) tries to replicate The International Dividend Achievers Index which includes companies that have increased their annual dividend for five or more consecutive fiscal years. The annual management fee is 0.58% and the current yield is 4.91%.
iShares Dow Jones Select Dividend Index ETF(DVY) is the first dividend focused ETF, launched in 2003. This fund has a 0.40% annual expense ratio and currently yields 4.65%.
BlackRock Dividend Achievers Trust (BDV) has the highest management fee amongst all dividend ETF’s at 0.83% annually. The dividend yield is 9.90%. This fund is a prime example of the fact that higher management fees do not lead to superior investment performance after all. I should also add that this fund is more actively managed as the advisor tries to select a varying number of dividend achievers which spot the highest yields.
PowerShares High Growth Rate Dividend Achiever (PHJ) consists of the 100 United States stocks with the fastest growing dividends for the past 10 years. This ETF yields 2.70% and has an annual management fee of
Full Disclosure: Long S&P 500
- MarketClub BONUS, 2 FREE MONTHS!
- International Dividend Achievers for diversification.
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