Dividend ETFs: Your Best Buy for Income?

As big banks have pushed their deposit rates to near zero and other safe fixed-income investments have seen their income dwindle, investors have had to find alternatives to produce the investment income they need. Especially for retirees and others who live off their investments, getting enough cash flow is essential to meet living expenses.

All week long, the Fool has looked at different ways to get more income from your portfolio. In previous articles about mortgage REITs and master limited partnerships, you got to learn about some unusual investments with unique attributes that help them produce huge amounts of income, some of which came with additional benefits like favorable taxation. Today, though, let's turn our attention to some more mainstream investments that have nevertheless captured the attention of income-seeking investors everywhere: dividend ETFs.

Joining the ETF craze
Exchange-traded funds have taken the investing world by storm. As an alternative to traditional mutual funds, ETFs have several advantages, including favorable tax attributes, relatively low costs, and ease of buying and selling throughout the trading day. As the number of ETFs in the market has soared far past the 1,000 mark, you can find ETFs covering nearly any niche of the market that you're interested in.

With the increased demand for income-producing investments, though, it's no surprise to see that dividend ETFs have become an especially popular category among investors. The biggest dividend ETFs, which include Vanguard Dividend Appreciation (NYSEMKT: VIG  ) , iShares DJ Select Dividend (NYSEMKT: DVY  ) , and SPDR S&P Dividend (NYSEMKT: SDY  ) , all have between $9 billion and $15 billion in assets under management, vaulting them into the upper echelons of ETFs by size.

Know what you own
Before you buy a dividend ETF, it's important to know what angle it takes toward buying stocks. Some ETFs try to bring you as much current income as possible by picking stocks that maximize current dividend yields. Others, such as the ETFs listed above, focus more on long-term payout growth, with current yield being only a secondary consideration in many cases. Still others look at fundamental factors like the total value of dividends a company pays as a determinant of how to allocate ETF assets across different stocks.

Moreover, you can buy dividend ETFs covering different cross-sections of the market. International dividend ETFs own foreign stocks with attractive dividend characteristics, while you can also buy sector-specific or sector-exclusive ETFs that either include or exclude stocks from certain industries.

In addition to knowing what an ETF owns now, it's also useful to understand the mechanics of how an ETF will change its holdings over time. Some dividend indexes that ETFs track end up changing their components fairly often, which can push overall costs higher. Others are more stable, allowing turnover levels to remain low and helping to keep costs down.

Risks
One danger from using dividend ETFs comes from the mechanics of how various dividend-stock indexes work. If the index that your ETF tracks doesn't let in new dividend-paying stocks until after a fairly long waiting period, then you may miss out on the benefits of owning those stocks at a particularly lucrative time.

One extreme example of this phenomenon comes from tech giants Apple (NASDAQ: AAPL  ) and Cisco Systems (NASDAQ: CSCO  ) , both of which have initiated dividend payouts recently. For Apple, going from paying nothing to making distributions at about a $10 billion annual clip to shareholders via dividends puts it in the top three dividend payers in the U.S. market, yet because of long waiting periods for many dividend indexes, most dividend ETFs won't own Apple for years. The same goes for Cisco, which has quickly raised its dividend since starting a payout in 2011.

Despite those concerns, dividend ETFs provide a convenient way to get much-needed income into your portfolio without taking on undue risk. By knowing your needs and choosing an ETF accordingly, you can find a dividend ETF that should be able to help you achieve your financial goals.

What other investments can get you the income you need?
Dividend ETFs are a key part of many investors' income portfolios, but they don't always have the oomph that some people seek from their investments. Tomorrow, we'll take a look at some individual stocks in the telecom industry as a more aggressive way to get income for those willing to take on specific company risk.

The idea of Apple as a dividend stock was unheard of for decades, but now, it's one of the biggest dividend payers in the market. But the stock has been plunging, leading some to question whether Apple remains a buy. Motley Fool senior technology analyst and managing bureau chief Eric Bleeker is prepared to fill you in on both reasons to buy and reasons to sell Apple, and what opportunities are left for the company (and more important, your portfolio) going forward. To get instant access to his latest thinking on Apple, simply click here now.


Read/Post Comments (3) | Recommend This Article (9)

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 December 20, 2012, at 11:20 AM, pondee619 wrote:

    Shouldn't an investor's focus be on total return? Stock appreciation and dividends.

    Is it better to own a stock with a 4% dividend rate and no price appreciation than a stock appreciating 4% per year with no dividend? Yes, you have to sell a part of your no dividend holding to live, but aren't you doing the same thing by taking your dividends and not re-investing them? Doesn't the issuance of a dividend lower the value of the company by that dividend amount?

    Why shouldn't ALL investors focus on total return?

  • Report this Comment On December 20, 2012, at 9:14 PM, TMFGalagan wrote:

    @pondee619 - Yes, you're right, although it's easier conceptually for people to think of dividends as spendable income and capital gains as growth to ensure future spending power. Obviously, you'd rather have a stock that rises 20% than one that pays a dividend of 10% and doesn't rise at all. But historically, dividend-payers have also put in better total returns. That's part of why dividend stocks get so much attention.

    best,

    dan (TMF Galagan)

  • Report this Comment On December 25, 2012, at 5:56 PM, fool3090 wrote:

    I'm a big, big fan of VIG. As per previous posts, I was way over-allocated to telecom and financials, so I was looking for something that would offer divvy growth and stability of divvy-paying companies. I didn't like the composition of DVY (way too many financials) and VIG was the perfect fit. Granted, it won't be for everyone, but it was the ideal chunk to anchor one bucket of my portfolio. I didn't want to risk individual shares of, say, utilities, consumer defensive, consumer staples, etc.

    As for the growth portion of the portfolio, I would err on the side of risk. If you are going for straight growth, forget Apple and other large caps. I allocate chunks of that bucket to small-cap growth and value (am a Hidden Gems member), where there is a greater chance of monster returns vs. large growth. But that's my situation and not yours, so take with a grain of salt. In any case, VIG is the bedrock (10 percent) of my risk-based assets. I really love the fact that we can have an ETF option rather than ultra-expensive mutual funds that have high turnovers and investment-style drifting.

    Disclosure: long VIG, co-own SDY in a joint account and long there, too.

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