Exchange-traded funds (ETFs) have come a long way since Standard & Poor's Depositary Receipts (SPDRs) first appeared in 1993. By the end of the first quarter of 2006, there were 212 ETF portfolios in the U.S., holding more than $321 billion in assets, according to the Investment Company Institute. The first ETF of dividend-paying stocks arrived in 2003. Now, there are eight such ETFs available to U.S. investors, with more on the way.
One reason for the spread of dividend-based and other specialized ETFs is the evolution of indexes, says James Pacetti, president of ETF International, a New York consultant (see BW Online, 5/5/06, "ETFs: Sliced, Diced, and Razor-Thin"). Indexes initially served to describe markets, and were later tweaked into growth and value segments.
INDEXES A GO-GO.
Today, says Pacetti, cheap computer power means that "quantitative strategies are being packaged as indexes." Current dividend ETFs are based on indexes created by four providers (see table): Dow Jones (DJ), Mergent, Morningstar (MORN), and Standard & Poor's, a division of The McGraw-Hill (MHP) Companies.
The first ETF devoted to dividend payers was the iShares Dow Jones Select Dividend Index Fund (DVY). The fund tracks the Dow Jones U.S. Select Dividend Index, which is based on the company's U.S. Total Market Index. To be in the dividend index, a stock must have positive historical five-year dividend-per-share growth, have paid out an average 60% or less of earnings over the past five years, and meet trading volume requirements. The dividend index consists of the top 100 stocks, ranked by yield, that meet these criteria.
Five dividend-oriented portfolios license Mergent indexes. The PowerShares Dividend Achievers Portfolio (PFM) is based on the Mergent Broad Dividend Achievers Index, which consists of U.S. equities with at least 10 consecutive years of dividend growth.
The PowerShares High Growth Dividend Achievers Portfolio (PHJ) takes the 100 stocks with the highest 10-year compound annual dividend growth rates from the index, and is modeled on the Mergent High Growth Dividend Achievers Index.
An ETF with a smaller selection of stocks is the PowerShares High Yield Equity Dividend Achievers Portfolio (PEY). It's based on the Mergent Dividend Achievers 50 Index, which holds the 50 highest-yielding stocks of the broad Mergent dividend index.
Vanguard also recently launched an ETF called Dividend Appreciation VIPERs (VIG). This is based on the Mergent Dividend Achiever's Select Index, which reduces the number of stocks in Mergent's broadest dividend benchmark by about a third.
How does this work? Both Mergent and Vanguard say the methodology is "proprietary." Vanguard will allow that the index eliminates real estate investment trusts (REITS) and limited partnerships. And the fund's prospectus notes that the index capitalization range is $198 million to $378 billion. But that range includes everything except micro-caps, which tend not to pay dividends. In effect, Vanguard and Mergent are saying: "Trust us." But this is not what most investors want to hear from an index fund.
U.S. investors seeking foreign dividend exposure in an ETF have only one choice, the PowerShares International Dividend Achievers Portfolio (PID). The fund is based on the Mergent International Dividend Achievers Index, which holds American depositary receipts and foreign common stocks that trade on major U.S. exchanges. To qualify, a company must have increased its dividend for five consecutive years. Mergent Vice-President Shirley Petersen observes:"There were not more than a handful (of foreign companies) that increased dividends for 10 years or more."
Here's another twist on dividends: the First Trust Morningstar Dividend Leaders Index Fund (FDL). This one mimics the Morningstar Dividend Leaders Index, which consists of the 100 highest-yielding U.S. stocks whose dividends are equal to or greater than what they paid five years ago.
In addition, the dividend must be"qualified," and can't exceed projected earnings. The index is weighted by "available dividends," meaning the stock's dividend multiplied by the "float" -- the percentage of shares available for trading. Like many dividend indexes, the Morningstar benchmark leans heavily to financial stocks. "You've got to mine gold where gold is," says Sanjay Arya, director of Morningstar Indexes.
If consistent dividend payers are what you're after, consider the streetTRACKS SPDR Dividend (SDY). This ETF is based on Standard & Poor's High Yield Dividend Aristocrats Index of the 50 highest-yielding stocks in the S&P 1500 index that have increased dividends for at least 25 consecutive years. The index is weighted by yield, which "accentuates the equity-income characteristics" of the group, says Srikant Dash, index strategist at Standard & Poor's.
WATCH THE EXPENSES.
How should you choose among these options? If you're seeking foreign dividends, PowerShares International is for you. If you value transparency, avoid the Mergent/Vanguard offering. Among the others, choices involve trade-offs. Indexes weighted by yield generally provide higher income than those weighted by market capitalization, but after-tax net can be lowered if the index includes REITs.
Morningstar's offering currently puts $1 out of every $10 into a single stock, which may give pause to the risk-averse. On the other hand, Morningstar reconstitutes its index twice a year (the rest do it annually). That helps to minimize the awkward position of holding a stock that no longer meets the index's criteria. Although ConAgra (CAG) recently cut its dividend, it remains the largest holding in the S&P index and won't come out until December.
You should also consider expenses. Among the dividend portfolios, they range from a low of 0.28% for Vanguard's ETF to a high of 0.50% for PowerShares. Your choice of a dividend-oriented ETF will depend on which mix of methodology, yield, total return, cost, and transparency best matches your investment needs.
One final thought: Making periodic investments in ETFs has been difficult because each transaction involves a brokerage fee. Online fractional-share programs, such as MyStockFund and ShareBuilder, allow you to make regular, automatic investments in ETFs at a low cost.