The explosion in the number of exchange-traded funds is both good and bad. The good is obvious -- investors have more choice than ever before. The bad is that the boom has created hundreds of ETFs, some with just one twist that makes them ever so slightly different than another fund on the market.
The boom is especially apparent in the hunt for dividend yield. To create the highest ETF yield, dividend stocks are becoming increasingly lumped together with no regard for quality. Dividend aristocrats are frequently combined with riskier alternatives. The best dividend ETF should offer a safe and reliable yield, like the funds below:
- Vanguard High Dividend Yield ETF (NYSEMKT:VYM)
- iShares U.S. Preferred Stock ETF (NASDAQ:PFF)
- Vanguard Dividend Appreciation ETF (NYSEMKT:VIG)
These funds don't swing for the fences on yield (not one yields more than 6%), but they're unlikely to go rapidly to zero, either. Here's the case for the funds listed above.
Vanguard High Dividend Yield ETF
This fund tracks the FTSE High Dividend Yield Index, a diversified index of high-yielding American stocks. Though it isn't actively managed, the index does have some thoughtful features that have helped it outperform indexes over multiyear periods.
The underlying index starts out with a universe of all U.S. stocks then throws out REITs, master limited partnerships, and microcap stocks. Then, one by one, it assembles a list of the highest-yielding stocks that make up 50% of the total market value of its investment universe. Finally, it invests in each stock, weighing positions by market capitalization, resulting in a portfolio that favors high-yielding large-cap companies.
One only need to look at its largest holdings to see that this fund doesn't swing for the fences. Top holdings included Microsoft, ExxonMobil, General Electric, Johnson & Johnson, and Wells Fargo as of the first quarter of 2016.
Given the low annual expense of just 0.09% of assets, diversification across nearly 500 stocks, and a yield of 3.24% (roughly 1.1 percentage points higher than the S&P 500), this would make an excellent low-cost dividend ETF choice.
iShares U.S. Preferred Stock ETF
Preferred stock fits the bill of offering relatively safe and reliable income, but with a yield higher than the stock market index. The fund yields about 5.8%, roughly 3.7 percentage points more than S&P 500 index funds, and carries a fair expense ratio of 0.47% of assets.
The largest of all preferred stock ETFs, this fund holds just under 300 different preferred stock issues, of which roughly 85% were issued by companies in the United States. (The U.K. and Netherlands made up substantially all of the remaining 15% at the time of writing.)
Preferred stock subjects investors to different risks than typical dividend-paying common stock. For one, preferred stock tends to trade more like a bond, so preferred shares will drop in value when interest rates increase.
Secondly, preferred stock is issued most frequently by financial companies -- banks, insurance companies, and real estate investment trusts. This fund reports that 82% of its assets are preferred shares issued by financial companies as of March 31, 2016.
The advantage, however, is that preferred stock has little correlation to common stock. This fund has a beta of 0.26, indicating that its movements are only weakly correlated to the movements in the broad market as measured by the S&P 500 index.
Vanguard Dividend Appreciation ETF
This fund tracks the NASDAQ U.S. Dividend Achievers Select Index, which includes stocks that have grown their dividends for 10 years in a row or more. It broadly excludes real estate investment trusts and limited partnerships from the index.
This fund also shows a bias toward large-cap stocks given that it is market cap-weighted. However, the underlying index caps individual stocks at no more than 4% of the index to ensure that it maintains a healthy level of diversification.
At the time of writing, the fund held stakes in 186 companies, many of which are household names. The top three companies as of March 31, 2016 were Microsoft, Coca-Cola, and Johnson & Johnson.
Its prospectus points out that "The Fund may purchase stocks that have relatively low dividend yields if the company issuing the stock has increased dividends in recent years." As a result, it typically yields no more than the S&P 500 (it yielded just 0.08% more at the time of writing).
However, as it carries annual expenses equal to just 0.10% of assets, and has a long record of beating the market, this fund is worth a second look despite its relatively low yield for a dividend ETF.
It's useful to know what an ETF is -- your portfolio might thank you.