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Investing in Dividend ETFs: Smart Strategy, but Not Risk-Free


These securities still have market risk and can experience more volatility than their bond cousins.

Thanks to risks in the market and extreme stock volatility over the past few years, many investors sought out more stability in their portfolios along with high levels of current income. Unfortunately, bond yields were quite low pushing many into high-dividend-paying stocks instead.

Beyond individual securities, investments in equity ETFs, which have stocks that pay high-dividend yields, emerged as a source of decent income for investors at this time. This has proven to be a pretty good strategy as intermediate-term bonds are still yielding below broad stock markets and equities are rising higher so far in 2012 as well (see: Emerging Markets Dividend ETFs for Income, Growth & Diversification).

Risk in Dividend ETFs

While dividend-focused ETFs may be safer than other equity funds, they are by no means risk-free. These securities still have market risk and can experience more volatility than their bond cousins.

Furthermore, there is always the risk that dividends could be cut if a company runs into trouble while bond investors are more likely to see their payments paid out on a regular basis thanks to their improved position in a liquidity event (see: Is The Bear Market For Bond ETFs Finally Here?).

Russell Product Launches

Nevertheless, Russell Investments, a global asset manager, looks to continue its push in the space with the launch of two new high-yield dividend ETFs. These funds are exposed to stocks that offer high dividend yields, helping to supplement current income at this time.

The two ETFs, the Russell High Dividend Yield ETF (HDIV) and Russell Small Cap High Dividend Yield ETF (DIVS) have been designed to replicate the performance of the US Large Cap High Dividend Yield and Russell US Small Cap High Dividend Yield Indexes, respectively, giving investors access to a portfolio of stocks in the US market that have outsized yields.

The two funds seek to build their investment portfolio by not only including those companies with high dividend yields, but also by evaluating each company on quality metrics. These metrics hope to find companies that have the capacity to payout more in dividends, grow their current payouts, while still having strong earnings.

This quality characteristic is then assessed on the basis of various financial measures such as cash flow generation capacity of the company, return on equity and what analysts expects as regards to the future earnings of the company.

By using this method, Russell looks to bring greater transparency to the stock selection approach while avoiding some of the pitfalls that hit many other products in the space. For example, many other funds concentrate solely on high yields without any scrutiny on financial strength, a situation that can lead to trouble if payouts start to become in danger.

Russell High Dividend Yield ETF

This fund, which looks to be passively managed, will track the performance of the Russell US Large Cap High Dividend Yield Index. The Index is a subset of the Russell 1000 and includes those stocks which have the highest dividend yield while passing the screening criteria lined-out above. The index holds a total of 75 stocks with Kraft Foods (KFT) being at the top position of the list.

The concentration risk of the ETF seems to be very high with 50% of asset invested in the top 10 holdings of the company, indicating the fund is not very well spread out (Alternative ETF Weighting Methodologies 101). The fund will charge a fee of 33 basis points a year for its services, roughly in line with other products in the space.

Small Cap High Dividend Yield ETF

This fund has been designed to replicate the performance of the Russell US Small Cap High Dividend Yield Index. The Index is a subset of the Russell 2000 and represents those stocks from the parent index which offers high dividend yields that are sustainable. The fund will hold a total of 150 stocks with expense ratio of 38 basis points.

Equity ETF Competition

The universe of dividend ETF has more than 40 funds designed to meet investor needs across a variety of sectors. The most popular among these is the Vanguard Dividend Appreciation (VIG). VIG has been specifically designed to include those companies in its holding list which have increased their dividends in the each of the last 10 years and tracks the performance of the Dividend Achievers Select Index.

VIG is one of the inexpensive funds in the ETF dividend space with an expense ratio of just 0.18%. The fund has a dividend yield of 2.23% and total return of 6.19% over one year period. VIG also has a history of constant dividend payments since its inception in 2006 (see: Top Three High Yield Financial ETFs).

Another ETF which has been popular among the investors is SPDR S&P Dividend (SDY). The fund, which is passively managed, replicates the performance of the S&P High Yield Dividend Aristocrats Total Return Index. SDY has been specifically designed to include those companies in its holding list which have increased their dividends in each of the last 25 years. The ETF charges fees of 35 basis points and delivered a total return of 7.25% over the past year.

Market uncertainty leads to increased investments in dividend ETFs as investors seeks for a certain level of income by their side. But consistency in dividend payment and how financially strong actually the company is should also be key considerations for choosing a dividend ETF.

Due to this factor, the recently launched products from Russell, DVIS and HDIV, could see a great deal of inflows from a number of investors. The funds will face heavy competition but their targeted portfolios and quality controls could help to mitigate some risks and make the new funds among the safest choices in the dividend ETF world.

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