Best Dividend ETF: 5 Contenders for the Top Income ETF

The best dividend ETF should pay a high yield from a diversified portfolio of dividend stocks and offer the potential for investors to earn additional returns from capital appreciation. To that end, here's a list of what I believe to be the five best dividend ETFs out of more than 100 dividend ETFs on the market today:

Sources: Vanguard, Charles Schwab, State Street Global Advisors, WisdomTree.

Before buying any of these ETFs, it's important to know how the funds work. Here's the case for each fund, and why each one deserves a spot in the list of the best dividend ETFs for an income portfolio.

Vanguard's dividend Goliath

The Vanguard Dividend Appreciation ETF lays claim to being the largest dividend ETF, with assets of more than $22.5 billion. It's not hard to see why this fund is so popular, given its tiny annual expense ratio of 0.09% of assets and a focus on high-quality dividend-paying companies.

This isn't your average dividend ETF. The fund tracks the NASDAQ US Dividend Achievers Select Index, which invests in companies that have paid increasing dividends for at least 10 consecutive years, excluding REITs and master limited partnerships. The index uses proprietary and undisclosed screening mechanisms to sort out the top companies from a dividend index.

Broadly diversified, the fund held 185 different mega and large-cap companies at the time of this writing, with its largest stakes in popular dividend stocks such as Johnson & Johnson, Microsoft, and PepsiCo. But keep in mind that this fund is focused primarily on capital appreciation over income. The fund's investments had an average yield of just 2.1% at the time of this writing, putting the ETF's yield roughly in line with the S&P 500.

What makes this fund so attractive to investors is that it has roughly matched the return of the S&P 500 while investing in companies with rock-solid dividend policies. In addition, a focus on blue-chip stocks with the capacity to grow their dividends resulted in less pain during the Great Financial Crisis, when the fund lost much less of its value than the stock market on average.

The best dividend ETF should generate regular income, pay a higher-than-average yield, and offer the opportunity for capital gains. Image source: Getty Images.

Vanguard's simple yield ETF

What would happen if you took a list of high-yield large cap stocks, sorted it by dividend yield, and then invested in the highest-yielding half? Well, you'd get something that looks a lot like the Vanguard High Dividend Yield ETF.

The strategy isn't particularly fancy, but it works. The Vanguard High Dividend Yield ETF tracks the FTSE High Dividend Yield Index, which invests in the highest-yielding of U.S. stocks in the FTSE All-World Index, excluding only REITs. The fund weights each stock by market cap, thus investing most heavily in dividend-paying large-cap companies.

Despite its simplicity, returns have been excellent, beating the S&P 500 marginally over the most recent three- and five-year periods, largely because of outsize dividend yields. At the time of this writing, the fund offered a yield of about 3.1%, roughly 50% more than the S&P 500.

Note that this is one of the most diversified ETFs on the list -- it holds more than 420 stocks -- yet it carries an annual expense ratio of just 0.08% a year. That's a very low price to pay to get broad diversification across dividend stocks in every sector.

Schwab's fundamentally focused dividend ETF

A late entrant into exchange-traded funds, Charles Schwab has rapidly attracted assets with its low-cost ETFs. The Schwab US Dividend Equity ETF is no exception, boasting a microscopic 0.07% annual expense ratio that makes it the least expensive of any fund on this list.

The prominent feature of this fund is that its methodology is designed to select from the very best of dividend-paying stocks. The ETF tracks the Dow Jones U.S. Dividend 100 Index, which invests in large-cap stocks that have paid dividends in each of the past 10 years.

Importantly, the index also considers fundamental metrics in stock selection, requiring that companies have high cash flow to debt, earn a high return on equity, offer a generous dividend yield, and have a history of dividend growth. Like other ETFs on this list, it excludes bond-like companies such as real estate investment trusts, which offer high yields but less opportunity for capital appreciation.

This fund favors large-cap stocks because of its market-cap weighting. The top three holdings are Intel, Procter & Gamble, and Microsoft, common companies in any high-quality portfolio. Its 3.1% yield stands out as one of the highest, but note that it isn't as diversified as other funds, as it holds only 100 different stocks.

State Street's royal dividend ETF

After a company increases its dividend for 25 consecutive years, it joins an elite group of stocks known as "dividend aristocrats." The SPDR S&P Dividend ETF invests in these companies by tracking the S&P High Yield Dividend Aristocrats Index, which includes companies that have consistently increased their dividends for 20 years in a row.

Relaxing the requirement to 20 years of dividend increases from 25 years doesn't necessarily cost much in the way of portfolio quality, but it does allow for a little more diversification. (A stricter dividend aristocrats ETF sponsored by ProShares holds just 50 stocks.) This ETF held 108 stocks at the time of this writing and was most heavily invested in traditional high-yield sectors including utilities, financial services, and industrials. 

State Street's ETF is a little different in that it weights stocks in the portfolio by their indicative yield. Thus, a stock that has a dividend yield of 5% will make up a bigger part of the portfolio than a stock that yields just 3%, for example. The result is that the fund tends to invest more heavily in slower-growing companies that return more of their income to shareholders. At the time of this writing, its three largest holdings were HCP Inc., People's United Financial, and Caterpillar. (Its largest holding, HCP, is a REIT, which would be excluded from many other ETFs on this list.)

Performance has been spectacular, as the ETF's annualized returns were about 0.5 percentage points better than the S&P 500 over the last five- and 10-year periods. This is especially impressive when you consider that the ETF carries a much higher annual expense ratio (0.35%) than other dividend ETFs. With a current yield of about 2.4%, the fund has a slight advantage over the S&P 500's 2.1% yield.

WisdomTree's fund for big yields from small stocks

Most dividend ETFs focus on large companies and completely ignore high-yield small caps. WisdomTree's SmallCap Dividend Fund is a great way to round out a dividend portfolio so that it includes dividend payers of all sizes, not just megacap companies.

This fund selects stocks by ranking all dividend-paying stocks by size and then throwing out the largest 300 stocks, as well as stocks with market caps of less than $100 million, which can be impractical for some funds to own. The largest companies that make up 75% of the remaining companies' total market cap are put into WisdomTree's large and mid-cap dividend ETFs. The smallest companies, which make up 25% of the value of the list, are put into the WisdomTree SmallCap Dividend Fund.

WisdomTree weights stocks in the portfolio by the total dollar amount of dividends it expects a company to pay over the next year. The result is a diversified portfolio of about 700 different investments, many of which won't be familiar to investors who primarily stick to American large caps. Targa Resources (oil and gas services), Cal-Maine Foods (egg farmer and distributor), and Covanta Holding Corp. (waste disposal) were recently the three largest companies in its portfolio.

Small caps typically generate higher returns, albeit with more volatility, than large-cap stocks. It's notable that the WisdomTree SmallCap Dividend Fund has beaten the returns of stock indexes large and small, trouncing both the S&P 500 (large caps) and Russell 2000 (small caps) over the most recent five- and 10-year periods. It also pays out a much higher dividend yield of about 3.1% vs. about 1.6% for the Russell 2000 and 2.1% for the S&P 500.

If there is one big downside, it's that the ETF leans toward the costly side. An annual expense ratio of 0.38% is cheap compared with active funds, particularly active small-cap funds, but it is the highest of any ETF on this list. That said, if the fund's forward returns look anything like its historical returns, investors will find it easy to look past higher expenses.