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ETF Investing: Diversification Vs. Dividends


With careful planning, you can get high-yielding dividends without the dramatic risk of stocks.

Many ETFs do not pay dividends to shareholders, so for these a comparison of value has to be made between dividend yields on a stock or mutual fund portfolio, and the value of diversification through the ETF's basket of securities.

Today, however, you can have the best of both worlds. You can get very high dividend yield with ETF or ETN products. For example Direxion's Daily 20 Year Plus Treasury Bear (TMV) is a 3x bear tracking fund. It is a multiple-security fixed income index tracking returns on 20-year and greater maturities in the US Treasury bond market.

As of October 1, annual dividend yield was 18.33%, placing TMV at the top of the 25 highest-yielding ETFs. Other double-digit ETFs on the list include WisdomTree Dreyfus Brazilian Real Fund (BZF) (12.74%); PowerShares FTSE RAFI Asia Pacific ex-Japan Portfolio (PAF) (12.45%); Direxion Daily 7-10 Year Treasury Bear 3x Shares (TYO) (12.27%); Market Vectors Junior Gold Miners ETF (GDXJ) (10.42%); and SPDR Barclays Capital High Yield Bond ETF (JNK) (10.23%).

However, just seeking double-digit dividends is not the sole criterion for picking an ETF. You also need to examine whether a fund is bullish or bearish. A bullish fund tracks its basket or index of securities; as it rises, so does the value of the ETF. A bearish ETF is the opposite. Share value rises if the basket's net value declines, so the ETF moves opposite.

Another important test is whether or not leverage is applied. This adds greatly to your profit potential, but also leverages up your risk. For example, TMV is a 3x bear tracking fund. This means it moves three times the value of its basket of Treasury bonds, but also moves in the opposite direction since it is a leveraged bear index. This means your profits accumulate at three times the bearish change of the basket -- it also means losses move just as quickly.

High yield is attractive in any kind of equity or debt markets, especially considering the dismal returns you can get anywhere else. So many stockholders have sought positions in high-yielding stocks. That by itself is a wise move unless you are sensitive to market risk. That high dividend could come at the loss of value in the stock itself. ETFs solve this problem partly with diversification.

If you want to make a dividend-yielding ETF really interesting, how about trading options? For example, TMV is already leveraged three times the change in the underlying basket. You can also trade options, creating even more leverage. For those worried about the dangers of leveraged ETF trades, using long options solves many problems. For a small investment, you control 100 shares without the 3x risk in the fund. As of September 30, 2011, TMV closed at $15.47 per share and many options were available, including:

So you could buy a November 16 call on TMV for only $155, or a 14 put for $105. That is far less than trading long or short on the 100 share cost of $1,547 and its associated market risk. With long options, the most at risk is the cost of the option, and you are never obligated to exercise. So even in a 3x fund, you can accomplish leverage even beyond the 3x by trading options.

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No positions in stocks mentioned.

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