The Devil Is in the Details

 | Apr 18, 2012 | 11:00 AM EDT
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I've been writing quite a bit about dividend ETFs over the last several months, and for good reason. Interest in dividend-paying stocks seems may have reached an all-time high as investors look toward equities to fulfill a function that was once carried out by bonds: delivering a meaningful current return. Innovation in the ETF industry has coordinated nicely with this movement, as the exchange-traded structure has emerged as a perfect tool for implementing low-cost and low-maintenance strategies that focus on dividends.

There is, no doubt, a lot of interest in dividend ETFs -- about four dozen are offered, with tens of billions in combined assets. There is also a lot of confusion about exactly what these products are designed to accomplish. A lot of investors have unrealistic expectations about ETFs with the word "dividend" in the name: They expect to get a meaty distribution yield that is materially higher than broad-based indices such as the S&P 500. But, in a lot of cases, so-called dividend ETFs are constructed to focus on the most consistent dividend payers -- a group that doesn't necessarily include companies with attractive yields.

One of the most popular dividend-focused ETFs is the S&P Dividend ETF (SDY), a product offered by State Street that debuted in 2005 and has since accumulated some $9 billion in assets. A look under the hood reveals that the requirements for inclusion in SDY are pretty tough to meet, as a company must have raised its dividend for 25 consecutive years to be included in the underlying index. But that extremely select group of stocks doesn't necessarily deliver a huge yield -- SDY has a 30-day SEC yield of about 3.1%. That's quite a bit higher than SPDR S&P 500 (SPY) (which comes in around 1.8%), but it's about 100 basis points below the Utilities Sector SPDR (XLU), whose yield comes in at about 4.1%.

It's also worth noting that SDY doesn't necessarily include the companies that make the biggest distributions. Tech giant Microsoft (MSFT) is an interesting example here. The company distributed more than $5 billion in payouts during its most recent fiscal year, making it one of the largest dividend payers in the world. But Microsoft isn't included in SDY because it hasn't been increasing its dividend for at least 25 years. In fact, the company isn't even close to that cutoff. Microsoft made its first distribution in 2003, meaning the earliest it could be found in SDY would be 2028.

In that vein, investors also shouldn't be expecting to see Apple (AAPL) make its way into SDY's portfolio anytime soon. With the first dividend coming later this year, AAPL would be eligible for inclusion in 2037 at the very earliest.

To be clear, I'm not railing on SDY as a poor product. It isn't, by any stretch of the imagination. But it's important to understand exactly what its function is. If you're looking for a portfolio of companies that are extremely steady in their distributions, SDY is a great tool. But if you're looking for a turbo-charged dividend yield, a fund like the Global X SuperDividend ETF (SDIV) could be a lot more useful.

Moreover, if you want to capture the universe of U.S. dividend payers, a product like the WisdomTree Total Dividend Fund (DTD) could be an appealing option. That ETF is linked to a dividend-weighted index, meaning that the biggest dividend payers get the largest allocations. Microsoft takes up the third-largest position, and Apple should appear once the company starts paying its dividends later this year.

The combination of dividend-paying stocks with the exchange-traded structure can be a very powerful one. It allows investors to achieve cheap, easy exposure to a strategy that has tremendous appeal to a wide range of investors. But it's important to understand that there are different types of dividend ETFs out there. Some value consistency while others value yield, and still others focus only on the total cash value of dividends. The decision over which of these aspects to highlight goes a long way toward determining the risk-return profile realized.


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