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Investors have discovered the appeal of dividend stocks in a big way lately. But before you go off and pick a dividend ETF to do your investing for you, make sure you know what you're getting into. If you're not careful, you could fall into some traps that you may regret down the road.
As dividend investing has become more popular, it's only natural that the ETF industry has responded by developing products that would meet investor demand for investments that hold dividend stocks. You can find dozens of ETFs that cater to dividend investors.
But with greater variety also comes the potential for greater confusion. Although their names may make you think that all dividend ETFs follow the same basic strategy, you'll actually find some huge differences in how these ETFs choose particular stocks and put together their complete investment portfolio. Depending on the strategy your ETF uses, you could easily see much different returns from a similar-looking fund that pursues another strategy.
To look more closely at some of these differences, let's consider the strategies and portfolios some of the major dividend ETFs use to meet their overall objectives.
The iShares Dow Jones Select Dividend ETF (NYSE: DVY ) from BlackRock follows an index that first sorts U.S. companies by dividend yield. Once it has the top-yielding stocks, the index excludes those with low trading volume. On an ongoing basis, quarterly reviews determine if companies that either cut dividends or have losses from continuing operations should be taken out of the index. Vanguard High Dividend Yield ETF (NYSE: VYM ) follows a similar process to pick high-yielding stocks.
A second strategy, used by ETFs from Vanguard, PowerShares, and State Street (NYSE: STT ) , focuses on stocks that have long histories of consistently increasing dividend payments on an annual basis. The SPDR S&P Dividend (NYSE: SDY ) tracks S&P's Dividend Aristocrats list, which includes only stocks that have increased dividends every year for the past 25 years. Both PowerShares Dividend Achievers (NYSE: PFM ) and Vanguard Dividend Appreciation ETF (NYSE: VIG ) draw their picks from the Dividend Achievers Select Index, which requires its components to have 10 years of annual dividend increases, as a tracking benchmark.
Finally, some fundamentals-based dividend ETFs select and weight holdings based on the amount of dividends paid. The WisdomTree Large-Cap Dividend ETF (NYSE: DLN ) weights its holdings by the total amount of cash each company pays out in dividends.
What to watch out for
The particular strategy that dividend ETFs follow makes them behave differently from one another. Here are some broad concerns to watch out for:
- The dangers of top yields. The highest-yielding stocks are obviously attractive to dividend investors, but they often carry big risks. If an ETF uses a process to cull out low-quality dividend stocks in the hope of avoiding high-yield traps, make sure you understand exactly how it works.
- Closet sector bets. Stocks in certain industries, such as telecoms and utilities, are more likely to pay significant dividends. If you rely too much on dividend ETFs for your stock exposure, you may end up with an undiversified portfolio focused too strongly on those sectors.
- Duplicated stocks. Conversely, you may find that because so many big-name stocks pay dividends, you already own a lot of dividend stocks in your core stock holdings. It may not even be necessary to add specific dividend ETF exposure to your portfolio.
ETFs do make investing easier for average investors. But that's no excuse for not knowing how your ETF invests. The best way to avoid any nasty surprises is to stay on top of exactly how each investment you own works.
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