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In order to fight against low interest rates and get the income they need, investors have gravitated toward dividend-paying investments as one of the remaining ways to get good yields for their money. But too many of those investors never realized that they could lose -- let alone suffer losses so big that they'd overwhelm even double-digit dividend yields.
Yet that's exactly what happened this year to investors in the iShares FTSE NAREIT Mortgage Plus ETF. Although the fund owns a virtual dream team of dividend powerhouses that produced a yield for the fund of more than 11%, that wasn't enough to stop the fund from posting a total-return loss of almost 10% for the year.
At first glance, the iShares ETF seemed like it had exactly the sort of stocks that any dividend investor would love. Real estate investment trusts with a focus on mortgage-backed securities make up the bulk of its portfolio, and with so many of its top holdings, including Annaly Capital (NYSE: NLY ) , Chimera Investment (NYSE: CIM ) , and American Capital Agency (Nasdaq: AGNC ) , having dividend yields in the 15% to 20% range, all those component mREITs had to do was to keep their prices stable and let the payouts do all the heavy lifting to get positive returns.
Moreover, all the stars seemed to align for mREITs to prosper in 2011. Amid concerns that interest rates would eventually have to go higher, sabotaging the high-leverage business models that mREITs use, the Federal Reserve came to the rescue, promising low rates through the middle of 2013. Meanwhile, the economy limped along slowly, failing to put any real pressure on rates and further supporting mREITs' use of borrowing to take advantage of interest rate spreads.
The dividends are not enough
But when it came down to crunch time, the iShares ETF couldn't deliver what its component stocks had seemed to promise. Along with Chimera, other REITs such as RAIT Financial (NYSE: RAS ) , Newcastle Investment (NYSE: NCT ) , and Redwood Trust (NYSE: RWT ) all posted total returns of around -25% even after taking their dividend payments into account. Real estate finance company iStar Financial (NYSE: SFI ) did even worse, losing 30% and paying no dividend at all.
Not all of the investments that the ETF held lost ground. American Capital Agency, for instance, weighed in with only a tiny capital loss that left almost its entire payout as profit. But the sparse positive contributions from American Capital Agency and the other investments with marginally positive returns weren't enough to offset the losses.
The lesson you need to learn
It shouldn't come as that big a surprise that an ETF that focused on a single narrow sector of the market would prove to be riskier than many had thought. As with any performance-chasing investment, mortgage REITs had had a good run going into 2011.
But the broader takeaway from the iShares ETF's performance applies to everyone, whether or not you ever owned an mREIT in your portfolio: When it comes to dividends, you shouldn't blindly assume that a dividend payment is gravy over and above a positive price return on a stock. Often, an investment has a high dividend yield precisely because investors are expecting the share price to drop. Just as a high-yield junk bond pays a greater yield because of the higher probability that it could default, high-dividend investments often include an additional risk premium in their payout yields -- and while you won't always get burned, you should expect your fair share of price drops that offset at least part of your dividend income over the long haul.
Be a smart dividend investor
Don't let the experience of mREITs in 2011 convince you that you have to avoid dividend stocks entirely if you want to be a successful investor. Many dividend payers have also given their shareholders big capital gains over the years. But what you shouldn't do is to count on having those dividends all to yourself while maintaining your principal unscathed. If you know the risks, then you'll be a smarter dividend investor.
We're always on the lookout for strong dividend-paying stocks with plenty of safety and security. We've put together 11 of them in The Motley Fool's latest special free report on dividends. Don't wait until your post-New Year's hangover -- get your free copy right now and go into 2012 with the right information.