With investors clamoring for income from dividend stocks, interest in exchange-traded funds that focus on dividends has never been stronger. But before you invest in a dividend ETF, you need to ask one question: Does that ETF own the dividend stocks you really want in your portfolio?
The dividend difference
At first glance, you might think that dividend ETFs would be pretty much identical. To a large extent, that turns out to be correct. The Vanguard High Dividend Yield ETF includes mega-caps Chevron and Coca-Cola near the top of its holdings list, as does Vanguard's other dividend ETF, Vanguard Dividend Appreciation. And while the SPDR S&P Dividend and iShares Select Dividend ETFs have some smaller companies in their top 10 holdings, they largely share the same holdings as their peers.
But when you look closely at the entire portfolios of these ETFs, what you'll find most startling isn't what you see but rather what you don't see. Dividend ETFs have some glaring omissions that many dividend investors will want to remedy on their own. Let's take a look at what stocks are missing from most of the major dividend ETFs.
The REIT stuff
High-yielding real estate investment trusts have taken the dividend world by storm. In particular, Chimera Investment (NYSE: CIM ) , American Capital Agency (Nasdaq: AGNC ) , and Annaly Capital (NYSE: NLY ) are among the group of mortgage REITs that pay dividends of greater than 10%. You'd think that dividend ETFs would be tripping over each other to own these high-yielding investments. But you won't find Annaly, American Capital Agency, or Chimera in any of the dividend ETFs I've mentioned.
The explanation may well be as simple as the fact that REITs differ from traditional stocks. To comply with tax laws, REITs have to distribute the vast majority of their income in dividends. That leaves their payouts vulnerable to fluctuations in earnings, which in turn makes their dividends more volatile than those of most stocks. Leaving them out of ETF portfolios reduces dividend ETF yields, but it makes payouts more stable -- a key consideration for many dividend ETF investors.
Mastering dividends
Another area that gets short shrift among dividend ETFs is master limited partnerships. MLPs offer not only impressive yields but also some tax-deferral benefits stemming from their investments in energy and natural resources. You won't typically find the double-digit yields that mortgage REITs offer, but MLPs Inergy (NYSE: NRGY ) , Terra Nitrogen (NYSE: TNH ) , and Penn Virginia Resource Partners (NYSE: PVR ) have attractive payouts that dwarf what most traditional stocks pay.
Again, though, MLPs may get left out of dividend ETFs because of their unusual structure. As partnerships, MLPs can cause tax headaches for investors, and owning them in an ETF would in turn potentially bring those complications to ETF shareholders as well.
Mind the gap
So if you want exposure to the full range of dividend stocks, what should you do? You have two main choices.
One option is just to buy your favorite dividend stocks separately. So in addition to one of the dividend ETFs discussed here, you could buy selected mortgage REITs, MLPs, and any other stocks you don't find among your ETFs' holdings.
As an alternative, you could supplement your all-purpose dividend ETF with ETFs geared toward those omitted categories. For instance, iShares NAREIT Mortgage (NYSE: REM ) includes Annaly, Chimera, and American Capital Agency. Alerian MLP ETF similarly owns shares of a variety of MLPs.
Whichever method you decide, don't let your dividend ETF selection disappoint you. By minding the gaps in their coverage, dividend ETFs can still serve you well.
ETFs aren't always the answer for the best dividends, though. Take a look at the Fool's free special report on 13 great dividend stocks that belong in your portfolio and learn how to skip the middleman in your quest for great dividend payers.
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