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Investors can't get enough of dividend stocks. With their unique combination of capital gain potential and regular income, stocks that pay dividends have never been in greater demand.
One of the most influential groups of investors who have been turning to dividend stocks lately have been those in or near retirement. After all, retirees need their long-held investment portfolios to generate cold hard cash -- cash they can't afford to go without. With more traditional conservative investments, such as bank CDs and Treasury bonds, paying extremely low interest rates lately, retirees have had difficulty making ends meet -- and the temptation to turn to riskier investments like stocks has become increasingly difficult to resist.
The question, though, is how to earn dividend income without exposing yourself to a huge amount of risk. Although dividend ETFs don't eliminate the risk of owning stocks entirely, they do help spread out that risk -- and the different strategies they follow hold some clues that observant investors can follow on their own.
3 trails to dividend cash
You can choose from many different dividend ETFs. But the strategies each fund follows can be vastly different from others, so you need to be sure you know what you're buying before you invest. In general, you can divide the vast bulk of dividend ETFs into three broad categories.
One group of ETFs, including the popular iShares Dow Jones Select Dividend ETF (NYSE: DVY ) , focuses on stocks that pay the highest current yields. Those stocks, which currently include tobacco maker Lorillard (NYSE: LO ) and rural telecom CenturyLink (NYSE: CTL ) , are sometimes solid investments, but they also carry risks. Current dividend yield doesn't speak at all to future growth, and often, the market awards high dividend yields to exactly those stocks it expects to languish in declining industries without much potential.
A second group of ETFs looks beyond dividend yield, choosing stocks with a demonstrated history of rising dividends. SPDR S&P Dividend ETF (NYSE: SDY ) , for instance, tracks the S&P Dividend Aristocrats, a group of stocks that has made annual increases to dividend payments for at least 25 consecutive years. You'll find some overlap between this ETF and the iShares fund, but you'll also find McGraw-Hill (NYSE: MHP ) , whose 2.5% yield won't land it on any top-paying lists. Consistent growth, however, arguably makes these stocks more stable than their higher-yielding counterparts. Other similar ETFs, such as Vanguard Dividend Appreciation ETF (NYSE: VIG ) , use slightly different selection criteria to pick stocks with substantial dividends and historical payout growth.
Finally, some ETFs follow different guidelines to pick stocks. The WisdomTree Large-Cap Dividend ETF (NYSE: DLN ) doesn't follow a market-cap or equal-weighted strategy for deciding the size of its respective stock positions; instead, it calculates the amount of cash each company pays in dividends and weights its portfolio accordingly.
Which should you use?
Perhaps the most obvious way to choose from among these ETFs is to look back at how each of them has performed in recent years. A quick look confirms that the high-yield strategy has resulted in a net loss for iShares investors in the past five years, while the SPDR fund has brought annual gains of around 2.6%, just edging out the S&P 500's 2% yearly average gain. The WisdomTree fund hasn't been around that long, but in the past four years, it also falls short of the SPDR's returns.
Past results, though, only tell part of the story. In my opinion, relying on stocks with a long track record of dividend consistency is simply the more conservative way to play. Yet during the financial crisis, long streaks of dividend payments from companies like General Electric and Dow Chemical came to an end, throwing investors for a loop and sending share prices plummeting. Before the crisis, banks had been among the best dividend stocks in the stock market, and so their losses had a disproportionate impact on dividend investors.
Dividend stocks deserve a place in the portfolios of retirement savers. But you should never think they're as safe as government-insured CDs. After all, they're stocks, and stocks are risky. But to minimize your risk and try to eke out better returns, the right dividend ETF may serve you well.
The best dividend stocks combine all sorts of valuable traits. Find them by reading the Fool's special report, "13 High-Yielding Stocks to Buy Today." It's free.