When it comes to passive income, many investors often flock to the stocks with the highest dividend yields. But the companies that pay the highest dividends might also have the least room to grow because there's nowhere left to invest their excess cash.
That's why some stocks that pay lower dividends could outperform higher-yielding ones over the long term. So to get the right balance of growth and income, investors should look for dividend growth stocks (companies that consistently hike their payouts while growing their earnings) instead of merely buying the stagnant ones with the highest yields.
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One popular exchange-traded fund (ETF) that focuses on dividend growth is the First Trust Rising Dividend Achievers ETF (RDVY 0.76%). Let's take a closer look at its strategies and see if it could be the best ETF for passive income.
What does this ETF own?
As its name says, the ETF tracks the Nasdaq US Rising Dividend Achievers Index, which comprises 50 stocks that meet four criteria. First, a company's trailing-12-month dividends must exceed its dividends over the past three- and five-year periods. Second, its latest trailing-12-month earnings per share (EPS) must exceed its trailing EPS from three years ago.
Third, a company must have a cash-to-debt ratio of more than 50% while maintaining a payout ratio no greater than 65%. Lastly, it must be ranked among the top 1,000 Nasdaq stocks by market capitalization and have an average three-month dollar trading volume of at least $5 million. Real estate investment trusts (REITs) are excluded from this list.
The Nasdaq US Rising Dividend Achievers Index holds only 50 stocks at any given time, but it rebalances its portfolio by swapping out about 25% of its holdings each quarter. That staggered approach allows it to reconstitute its entire portfolio over the year without abruptly changing out all of its stocks. The First Trust ETF follows those same quarterly rebalancings.
When it rebalances its portfolio, the stocks that have the longest streak of annual dividend hikes, the highest dividend yields, and the lowest payout ratios rise to the top. As of this writing, its top holdings include eBay, Meta Platforms, Microsoft, Bank of New York Mellon, and JPMorgan Chase.
What are the First Trust ETF's biggest weaknesses?
The Rising Dividend Achievers fund promotes itself as dividend growth ETF, but its 12-month distribution rate of 1.67% is pretty low for an income ETF. By comparison, the popular Schwab U.S. Dividend Equity ETF -- which tracks the more conservative Dow Jones U.S. Dividend 100 Index -- pays a much higher trailing-12-month distribution of 3.97%.
The Rising Dividend Achievers ETF is more volatile than traditional dividend ETFs like Schwab's because it holds a higher mix of mid- to large-cap growth stocks with rising earnings instead of slower-growth dividend stalwarts. The First Trust ETF's total expense ratio of 0.48% is also high compared to Schwab's ratio of 0.06% and that of many other dividend-focused ETFs.
What are its core strengths?
The Rising Dividend Achievers ETF might charge higher fees and pay lower dividends than its peers, but it has still rallied 170% over the past decade and delivered an impressive total return of 224% after reinvesting those dividends. By comparison, the Schwab U.S. Dividend Equity ETF's price only rose 103% and delivered a total return of 179%. It also outperformed other conservative dividend funds like the Vanguard Dividend Appreciation ETF and the iShares Core Dividend Growth ETF.
Therefore, the Rising Dividend Achievers ETF's focus on companies with consistent earnings growth, reasonable payout ratios, and rising dividends seems to be paying off.
But is it the "best" ETF for passive income?
The Rising Dividend Achievers ETF is attractive for investors who want a good blend of growth and income. But it still unperformed the S&P 500's total return of 239% over the past decade, so it would have been easier to simply buy a low-cost S&P 500 ETF instead.
It certainly isn't the "best" ETF for retirees to generate passive income. Its low yield makes it unappealing for passively covering monthly living costs, its high expense ratio erases nearly a third of its yield, and it's more volatile than other dividend ETFs. Investors who are interested in the First Trust Rising Dividend Achievers ETF should recognize those flaws before pressing the "buy" button.