On the heels of last week's article, in which I noted the drawbacks of some popular dividend-oriented mutual funds, I received a large volume of email from readers seeking more information on the iShares Dow Jones Select Dividend Index
Though it wasn't my intention to turn this topic into a bound edition of War and Peace, your responses tell me that there is enough interest in the subject to warrant a follow-up article, and I'm happy to dedicate today's piece to the task.
Apparently, many of you like to supplement individual, dividend-paying stocks -- like the ones I recommend each month in Motley Fool Income Investor -- with a collection of regular open-end mutual funds, exchange-traded funds (ETFs), or closed-end mutual funds (CEFs).
I understand and encourage the practice, since it can be a good way to achieve stable growth and income while increasing diversity. When it comes to funds, however, I prefer to focus only on ETFs and CEFs, which I believe offer some of the best solutions for most income investors.
With that in mind, I'll first give you some background on these tools, which, again, can help you achieve both income and diversity while maintaining the low-cost approach to investing that the Fool has always championed.
As many of you know, transactions in open-end mutual funds occur only once per day at the market's close, and they take place at a price that's equivalent to the fund's net asset value (NAV). ETFs, on the other hand, are basically mutual funds that trade on a major exchange throughout the day, just like ordinary stocks.
Because ETFs trade on the open market, their prices are determined by supply and demand. That demand is most often driven by the value of the underlying securities that make up the fund, but not always. This means that it's possible for the price of an ETF to be higher or lower than its NAV, though the difference has historically been extremely small.
CEFs, on the other hand, have many similarities to ETFs, but they are usually much more actively managed, and it's common for their shares to trade at a more significant discount or premium to NAV -- say, in the 5%-10% range.
Most ETFs try to match the performance of a particular index or benchmark, and several CEFs do the same. For instance, the first ETFs, called Spiders
The tao of dividends
Prior to last week's mention of the iShares Dow Jones Select Dividend Index, I had recommended this ETF to Motley Fool Income Investor subscribers in December 2003 via the special report The ABCs of ETFs. Though the fund had just launched on Nov. 3, 2003, the fact that it was freshly minted didn't bother me because the proven companies it holds have been around for ages -- I dare say you've heard of Altria
iShares Select Dividend has performed admirably for our readers since then, beating the S&P 500, and it remains one of the most favorable new offerings for dividend lovers. Indeed, it remains the only ETF offering that invests solely in dividend-paying stocks.
But not all dividend payers make the cut, and therein lies the beauty of the fund. Dividend Select does seek to invest in the 50 highest-yielding companies in the Dow Jones U.S. Total Market Index, but, of course, we know that "highest yielding" isn't always a good thing. To that end, the fund invests only in companies that have proven track records when it comes to consistent dividend payments.
Prospective companies must have a positive historical five-year dividend-per-share growth rate and a five-year average payout ratio no greater than 60%, and the average daily trading volume (determined annually) must be more than $1.5 million. To keep the strategy intact, the index is rebalanced once per year, and each company's weighting is then determined by its annual dividend.
The fund boasts a respectable expense ratio of 0.4% and a current yield of 3.35%, and it pays dividends quarterly. All in all, these traits should make it a welcome addition to any income-oriented portfolio.
One caveat: Though the fund excludes real estate investment trusts (REITs) in its screening process, Dividend Select does have a somewhat heavy exposure to financial and utility stocks.
Now, this exposure doesn't particularly worry me, as I happen to be bullish on several companies within both sectors. Still, though it partly goes with the territory of being a dividend investor, these types of securities can increase interest-rate-related volatility.
The Foolish bottom line
OK, I intended to also provide you with a CEF recommendation today with some similar attributes. But since I'm running a bit long here, I'll have to save that one for next week. (I suppose my subconscious desire to pen a spinoff of War and Peace remains alive and well.) So, I'll expand the playing field a bit and provide you with some more income investments next Monday. Until then....