Could This Really Be the Perfect Dividend Investment?

With bond rates at rock-bottom levels, if you want income from your portfolio, dividend stocks are hard to beat. But with the dangers that some dividend stocks present, especially those with particularly high yields, conservative investors are fearful about putting too much of their hard-earned nest eggs into the stock market.

A brand-new exchange-traded fund from Invesco's PowerShares seeks to ally investors' fears by giving them the best of both worlds: attractive dividends and low share-price volatility. Let's take a closer look at what many might see as a perfect combination in an income investment.

How the ETF works
The PowerShares S&P 500 High Dividend Portfolio is just a week old, but already, it has attracted a fair amount of attention from ETF analysts for its features. The ETF follows an index-driven investment philosophy, helping it keep fees down to a relatively low 0.30% annually. Yet the methodology behind the index is sophisticated and dynamic, so that you can expect the stocks you own to change regularly along with prevailing market conditions.

To determine which stocks it holds, the PowerShares ETF takes the 75 highest-yielding stocks within the S&P 500, with the additional restriction that no more than 10 stocks can come from any single sector. The ETF then takes those 75 stocks and picks the 50 that have had the least volatile share-price movements over the past year.

Once the ETF has made its 50 selections, it then figures out how much of each stock to buy by looking at their dividend yields. High-yielding stocks get the heaviest weights, but again, a 3% cap applies to any single stock, and no sector can account for more than a quarter of the overall fund.

The index is subject to rebalancing twice a year, at the end of January and July. As a result, some stocks may only stay within the ETF for six months if their volatility rises, and the respective weightings among stocks can respond quickly to changes in dividend payouts.

Who's in and who's out
The nice thing about ETFs is that they release their holdings on a daily basis, making it easy to see which stocks are included in any given portfolio. The bonus with the PowerShares ETF is that thanks to its methodology, you can also figure out which stocks were excluded due to high volatility.

For instance, telecom stocks have historically had some of the highest dividends in the market, because their businesses tend to throw off a lot of cash flow. Yet while four of the five high-yielding telecom stocks made it into the ETF, Frontier Communications (Nasdaq: FTR  ) didn't make the list.

Similarly, stocks in beaten-down subsectors failed to make the cut. Cliffs Natural Resources (NYSE: CLF  ) yields nearly 6%, but the stock's plunge due to falling worldwide demand for iron ore and metallurgical coal for steel production presumably boosted its volatility too high for inclusion.

Yet not every losing stock got the boot. Pitney Bowes (NYSE: PBI  ) has fallen 30% in the past year as investors worry about its ability to innovate beyond its historical leadership role in mail-metering devices to capitalize on the rapidly changing digital delivery and communications industry, but it earned a top 3% weighting from the ETF. Utilities also play a key role, making up almost 22% of the fund and including well-known PPL (NYSE: PPL  ) and Exelon (NYSE: EXC  ) , which give investors different angles on the industry. With its specific emphasis on nuclear energy, Exelon has a much different risk profile from many more conventional utilities, and that gives dividend investors more diversification.

Try it out or wait and see?
So far, investors haven't flocked to the PowerShares ETF, with just $4 million in assets under management. But with only six trading sessions under its belt, investors may simply be waiting to see how it performs. With a solid investment philosophy and good names in its portfolio, the ETF should give dividend investors the security and income they want.

For individual stock investors, though, the interesting question is whether you should avoid stocks the ETF left out. For instance, Frontier's juicy dividend is tempting, but every Frontier investor has to understand that it's not a sure thing. A huge acquisition has transformed the company forever. Will the move bear fruit, or are investors destined for another disappointing dividend cut? Our premium research report answers the key question of whether Frontier Communications is a buy by walking you through all of the key opportunities and threats facing the company. Better yet, you'll receive a full year of updates to boot. Click here to learn more.


Read/Post Comments (5) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 26, 2012, at 1:20 PM, gskinner75006 wrote:

    I'm keeping an eye on SPHD myself. Just waiting a bit to see how the returns are going to pan out. (If that's not the symbol the article is referencing, sorry about that!)

  • Report this Comment On October 26, 2012, at 4:37 PM, TMFGalagan wrote:

    @gskinner75006 - SPHD is indeed the ticker. It's new enough that our ticker list didn't even include it yet - otherwise I would've put it in.

    best,

    dan (TMF Galagan)

  • Report this Comment On October 27, 2012, at 7:58 AM, rsinj wrote:

    I think creation of such an ETF at this particular time is just playing right into the bubble scenario and what happens at the tail end of a market rise and Average Joe is piling in.

    Similar to bonds and bond funds, it's extremely questionable why people continue dumping money into them now. Anyone with any sense of finance and economics knows that the day of reckoning is on the horizon when interest rates will be increased. When that happens, the stocks in this ETF and thus the ETF are going to get hammered. So, for the time being, people will put money into this ETF and ignore the warning signs. Better yet, as rates rise, and the ETF price does go down, more people will pile in - because the dividend rate will go up, and then the ETF has an even better story to tell. Brilliant strategy for Invesco launching now, poor investment thesis for investors...at least for the time being. We should begin looking at this ETF and buying when interest rates are back in the vicinity of 5%, if not higher.

  • Report this Comment On October 27, 2012, at 8:17 AM, rsinj wrote:

    Regarding FTR specifically, I make it a habit to stay away from stocks/companies that carry debt of more than they have in annual revenues.

    I'm fully aware that some companies are in capital intensive businesses which require lots of investment. However, generally these companies have very low profit margins (one result of the high debt), and like every other business they do have their up and down cycles. When they go through a down cycle, it hits extremely hard because they are highly leveraged. Then they have to worry about violating loan/debt covenants, reducing or pulling of credit lines, and an ensuing liquidity crunch. Obviously dividends are the first thing to go in these situations, then the stock craters, debt/equity goes even higher, creditors get cold feet, and it's a downward spiral. I've seen it happen all too often.

    This is one particular reason why I think for many people they should avoid ETFs like this one. If they are interested in the philosophy behind it, just look at their holdings/purchases, apply your own additional screening of those stocks, and directly purchase the best of the bunch. Stock commissions are so low these days, and difference in cost can easily be made up in gains.

  • Report this Comment On October 28, 2012, at 12:29 PM, gskinner75006 wrote:

    It is true, if your not paying attention to dividend yields vs. interest rates, you could be in for a surprise with some of the ETF's and CEF's. Even a number of good stocks could see a decline as those seeking better returns move back into savings accounts, bonds, etc... that offer higher interest payments.

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