Best ETF for 2012: SPDR S&P Dividend

This article is part of our Best ETFs for 2012 series, in which we're seeking out the top-performing ETFs for the coming year.

Predictions for how the economy will fare next year are flying fast and furious and range from the optimistic to the downright doomsday-ish. And while it remains to be seen exactly how the global economy will play its cards next year, investors should be thinking ahead and making plans for 2012 right now. That's hard to do in such an uncertain, volatile environment, but there are a few areas of the global economy that will likely fare better than others next year -- and that means opportunity, if you know where to look.

Ringing in the new year
One exchange-traded fund I think will do quite well in the coming year is the SPDR S&P Dividend ETF (NYSE: SDY). This fund tracks the S&P High Yield Dividend Aristocrat Index, which tracks the 60 highest dividend-yielding members of the S&P Composite 1500 Index that have increased dividends every year for at least 25 consecutive years. That means you'll be getting access to high-quality companies like these top holdings, all of which have trailing dividend yields in excess of 3%:

Source: Google Finance.

It's not exactly news that domestic large-cap stocks have been the dogs of the past decade or so. While the S&P 500 Index has gained 2.9% over the most recent 10-year period, small caps, as measured by the Russell 2000 Index, were up 6.2%. Of course, that disparity in performance has led to a disparity in prices -- small-cap stocks as a whole are much more richly valued than their large-cap counterparts.

According to data from Birinyi Associates, the estimated forward 12-month price-to-earnings ratio for the small-cap-focused Russell 2000 Index is 21.4, compared to just 12.5 for the large-cap-centered S&P 500 Index. Since higher relative P/E levels tend to predict lower future performance, there's a pretty good chance that large-cap stocks may outperform smaller names in the next few years. And while the SPDR S&P Dividend ETF has a much smaller average market capitalization than the megacap-focused S&P 500 Index, it should still benefit nicely when large caps take over market leadership. Its 3.3% yield is nothing to sneeze at, either.

It pays to pay
But beyond the argument for holding larger stocks at this point in the market cycle, there's another reason why investors should make room in their portfolio for dividend-producing stocks -- over time they have historically outperformed stocks that don't pay dividends. In fact, here's how dividend-paying stocks fared compared to non-dividend payers over the past nearly four-decade span:

Source: Ned Davis Research; analysis by Allianz Global Investors.

Because financially troubled companies aren't likely to be handing out dividends to shareholders, steady and increasing dividends are frequently a sign of healthy operations. Healthy companies are much more likely to post meaningful returns over time. Now that's not to say that a stock is not worth buying unless it pays out dividends, but dividend payments can often serve as a useful screen in assessing the financial health and stability of a company.

And while economic data has been fairly positive as of late, the eurozone situation is still a big unknown and a huge potential risk to the domestic economy in 2012. If another downturn does materialize, financially healthy, cash-rich companies are hands-on favorites to outperform. And even if we manage to escape the situation in Europe without significant harm to the global economy, there's little chance that growth will take off in the next few years. That means high-quality companies with healthy balance sheets and lots of cash on hand are ideally positioned to thrive in a continuing slow-growth environment.

All in moderation
While you shouldn't devote all of your large-cap exposure to a dividend-focused fund like the SPDR S&P Dividend ETF, about half is a good starting point. That means if you have a 30% allocation to domestic large-cap stocks, about 15% of your portfolio can be dedicated to dividend-producers like this fund. You still want to leave some room for more growth-oriented large-cap names and megacap-focused funds to keep your large-cap allocation balanced. This holds true even for more conservative investors who are already in retirement.

No one knows what the market will do in the short run, so it's important to keep a long-term focus when investing in exchange-traded funds like this, or any funds at all. But if there's one area of the market you don't want to skimp on in 2012, it's large-cap dividend-producers like the SPDR S&P Dividend ETF.

Stay tuned throughout our series on the Best ETFs for 2012 to find out about all of the picks our Foolish contributors have made. Click back to the series intro for links to the entire series.