Delving Into Dividend ETFs

Dividend ETFs have the same advantages over traditional mutual funds as regular ETFs, including low fees and the ability to buy and sell during the day. Investors seeking dividend-friendly investments will now find an ever-expanding menu of ETF options. But these funds aren't all alike, and an investor needs to understand how they differ to determine which fund best meets their risk and return objectives.

Dividend ETFs perform differently because they track indexes from various providers, including the better-known Dow Jones and Standard & Poor's, to lesser-known index creators Mergent, Morningstar, and WisdomTree.

Some of the newer ETFs may be very concentrated, with little industry diversification, making them riskier investments. Financial stocks are a common holding in dividend funds, and these stocks can be extremely sensitive to shifts in inflation and interest rates. Since tax rules can be complex, to say the least, be aware that short-term holders of these funds may not quality for the lower 15% federal tax rate on long-term capital gains. Furthermore, some dividends paid by a fund may not qualify for the 15% rate.

Sampling the market
The Vanguard Dividend Appreciation Fund (AMEX:VIG) is a one of the cheapest dividend ETFs, with an expense ratio of 0.26%. Some rivals charge as much as 0.60%. But fees aren't everything here. VIG's current yield -- slightly less than 1.6% -- is on the low side, as is its total return of roughly 7% since its inception in late April 2006.

VIG is benchmarked to the Mergent Dividend Achievers Select Index, a subset of the Mergent Dividend Achievers Index -- a market-cap-weighted index of stocks with a consistent history of increasing dividends. Its holdings are highly concentrated in three sectors: consumer staples at 23%, financials at 20%, and industrials at 17% of assets. The top five stock holdings include Johnson & Johnson, GE, ExxonMobil, AIG, and IBM, each representing roughly 4% of assets.

Among other ETFs focusing on high-yielding equities, the iShares Dow Jones Select Dividend (NYSE:DVY), the first dividend ETF, has gathered more than $7 billion in assets. It invests in 100 of the highest dividend-yielding securities (excluding real estate investment trusts) in the Dow Jones U.S. Total Market Index.

First Trust Morningstar Dividend Leaders (AMEX:FDL) invests in the top 100 stocks of the Morningstar Dividend Leaders Index. These are the index's highest-yielding stocks, ranked by the consistency with which they pay dividends and the ability to sustain those dividends going forward. Three securities -- Citigroup, Bank of America, and Altria -- together make up more than one-fourth of the fund.

State Street SPDR Dividend (AMEX:SDY) invests in the 50 highest dividend-yielding S&P Composite 1500 constituents. This index tracks equities that have consistently increased dividends every year for at least 25 years. Investing in these long-term dividend-paying stocks reduces the risk that the fund's holdings will cut their dividends.

For dividend daredevils
More adventurous investors might consider the Claymore/Zacks Yield Hog ETF (AMEX:CVY), which aims to double the yield of other dividend-paying ETFs. The fund invests in high-yield securities such as preferred shares, master limited partnerships, closed-end funds, American Depository Receipts, and real estate investment trusts. It's a riskier play, since the holdings don't all have a long history of regular, stable dividends.

Paying the piper
Tax law changes in 2003 lowered the tax on most dividends to 15%, making dividend-paying stocks more appealing. This law is set to expire at the end of 2008, and if it does, dividend-paying stocks may become less desirable.

Dividends have historically been an important source of stocks' overall returns, and regardless of the tax laws, they're likely to be an essential component of many investors' portfolios. Complex tax codes and tenuous laws challenge dividend investors to keep an eye on details. That can be devilishly difficult, but investors would be small-f foolish not to make the effort.

Discover more about the world of ETFs in our ETF Center, and get the Fool's list of top dividend-paying stocks -- including selections Johnson & Johnson and Bank of America -- with a free 30-day trial to Motley Fool Income Investor.

Fool contributor Zoe Van Schyndel lives in Miami and enjoys the sunshine and variety of the Magic City. She does not own any of the funds or stocks mentioned in this article. The Motley Fool has a disclosure policy.