Exchange-traded funds give you more opportunities to invest in exactly what you want than ever before. But the sheer number of ETFs can challenge even the smartest investors, especially when different ETFs target the same types of investments. In those cases, you need to look closely at all your choices to pick the best ETF you can get.
Nowhere is that more evident than in the universe of dividend ETFs. With dividend-paying stocks reaching new heights of popularity in recent years, a rash of dividend-focused funds has hit the market. Sometimes, even telling one ETF apart from another can be tricky. But Standard & Poor's recently took a stab at analyzing which dividend ETFs reign over their competitors.
The best ETFs own the best stocks
S&P started with a very simple premise: To find the top dividend ETFs, you should first know which dividend stocks are the most promising. Then you can go through the holdings lists of various ETFs to see which ones most closely resemble the idea dividend-stock portfolio you came up with.
S&P's analysis started with the sectors of the S&P 500 that pay the highest dividend yields: telecom, utilities, consumer staples, and industrials. From those sectors, S&P removed companies that had lower yields than the overall 2% payout of the entire S&P 500, as well as companies with problems in their fundamental financial numbers. Those top stocks, in S&P's opinion, included Windstream (Nasdaq: WIN ) , Altria (NYSE: MO ) , and United Parcel Service (NYSE: UPS ) .
Finally, the analysis matched up ETF portfolios against S&P's master list. When the dust settled, S&P picked two dividend ETFs: WisdomTree Total Dividend and Vanguard High Dividend Yield Index (NYSE: VYM ) .
But what makes a dividend stock the best?
Before you run out and buy those dividend ETFs, however, take a moment to consider a very important thing: whether you agree with S&P's selection process for the best dividend stocks. Although the S&P analysis is a perfectly reasonable way to pick good dividend stocks, it definitely isn't the only way -- and you might prefer a completely different measure entirely.
Perhaps the most obvious aspect of a stock-picking strategy is how important current yield is. If you need to live off the dividends from your portfolio, then giving top billing to a high yield makes plenty of sense. But for more growth-oriented investors who don't necessarily need large dividend payments right now, looking at dividend growth rather than raw current yield may get you better long-term results.
As an example, take Parker-Hannifin (NYSE: PH ) . The company has an impressive streak of 54 straight years of raising its dividend payment annually; and over the past five years, those raises have been substantial, amounting to 15% average annual growth. But because it yielded just 1.9% as of the end of July, it's probably not a stock that would have made S&P's list. You could say much the same thing about Sherwin-Williams (NYSE: SHW ) and other high-dividend-growth, mid-range-yield dividend stocks. And if those are the kinds of stocks you want to focus on, then S&P's dividend ETF recommendations may not make much sense for you.
Pick what you want
It's because different investors want different things that you'll find so many dividend ETFs out there. Even within Vanguard's ETF universe, the Vanguard Dividend Appreciation ETF (NYSE: VIG ) takes a different tack from its high-yield counterpart, settling for lower yields but insisting on choosing stocks with track records of growing dividends over time. The stocks that you'll find among its holdings may not make S&P's ideal list, but they might well be on your ideal list.
One of the most important lessons you'll ever learn as an investor is that just because an investment is the best for one person, that doesn't mean it's the best choice for you. The nice thing about having ETF choices is that you can usually find one that gives you almost everything you're looking for from an investment. The wide selection may make picking a fund a bit more challenging, but you'll find the end result much more satisfying.
Read more about ETFs and how they can help you. The Motley Fool's special free report on ETFs has some great ideas for you to look at further.