In 2020, exchange-traded funds (ETFs) managed over $7 trillion worth of assets. The investment strategies for ETFs range from simple stock market trackers to niche themes, so there is something for any kind of investor. Dividend ETFs are one of the more popular strategies.
In this post, we’ll explore what dividend ETFs are, how to choose one, and how you can build your own alternative fund to earn a similar or even higher yield.
What Is a Dividend ETF?
First, let’s get clear on what an ETF is. Though they are similar to mutual funds, ETFs are traded on a stock exchange and sold via brokers rather than financial advisors. Like regular stocks, they have tickers and quoted share prices.
The investment strategy for a dividend ETF focuses on stocks that can generate a high dividend yield. As of September 2021, the average dividend yield for the S&P 500 is just 1.3%, so anything above that could already be considered high. Each fund, however, has different targets, which are detailed in a prospectus.
Some dividend ETFs make payouts on a monthly or quarterly basis, while others reinvest the dividends.
The benefits of a dividend ETF are straightforward:
- Built-in diversification: An ETF typically holds a range of stocks across different industries and sectors.
- Lower volatility: A diversified ETF often has lower volatility than individual stocks.
- Simplicity: It’s easy to invest in an ETF. Just a few clicks, and you own a portfolio of assets.
This convenience, however, comes at a cost. Dividend ETFs, like other specialist funds, have expense ratios (i.e., the fees you pay for the fund) of up to 0.5% and even higher. For example, if you have $100,000 in an ETF, you would pay $500 per year to cover the fund’s costs. For comparison, the Vanguard 500 Index Fund ETF (NYSEARCA:VOO), a popular low-cost index ETF, has a gross expense ratio of just 0.03%.
Of course, the expense ratio is not the only thing to look at when choosing a dividend ETF.
How to Choose a Dividend ETF
When selecting a dividend ETF, you should start with the prospectus. That document contains a detailed description of the fund’s investment strategy and rules for buying and selling different assets. Make sure that you understand the strategy — if you don’t, you might end up taking on more risk than you want.
On a website like Morningstar, you can research different metrics for a fund’s portfolio. For a dividend ETF, the most important numbers would be dividend yield and expense ratio.
Additionally, you should check the ETF’s portfolio “exposure.” That’s the investment jargon for money invested in a specific asset. You should look for a fund that doesn’t have excessive concentration (over 20%) in a specific sector.
As the next step, you can drill down and explore the ETF’s top holdings. Ideally, these should be companies that you recognize and want to hold in your portfolio.
As the last step, you can review the fund’s past performance. Don’t just focus on the previous year. Instead, look for consistent returns over a longer period — at least five years.
Important: Remember that past performance does not guarantee that the fund will continue to deliver the same results. Investment conditions change all the time, and what has worked previously might not work in the future.
Examples of Dividend ETFs
To help you with your research, here are some popular dividend ETFs. Please note that this selection is meant for informational purposes only and is not an endorsement.
- The Global X SuperDividend US ETF (NYSEARCA:DIV): With $655 million of assets under management (AUM), this fund invests in the 50 U.S. equities with the highest dividend yields. The fund’s total expense ratio is 0.45%, and the dividend yield is 5.44%.
- Invesco High Yield Equity Dividend Achievers ETF (NASDAQ:PEY): This is a high dividend yield ETF that tracks the NASDAQ US Dividend Achievers 50 Index. The fund currently has $936 million of AUM. The index picks its 50 stocks based on dividends and growth in dividends. The fund’s expense ratio is 0.52%, and its dividend yield is 4.54%.
- WisdomTree US High Dividend Fund (NYSEARCA:DHS): This ETF tracks high-yielding U.S. equities and has $798 million in AUM. The stocks are assigned weights based on a score, which includes value, quality, and momentum. The fund’s expense ratio is 0.38%, and its dividend yield is 4.06%.
- iShares Core High Dividend ETF (NYSEARCA:HDV): This fund invests in 75 established dividend-paying companies and screens the companies to ensure adequate financial health. This ETF has $7 billion of AUM. The expense ratio is 0.08%, and the dividend yield is 3.53%.
- SPDR S&P Dividend ETF (NYSEARCA:SDY): This fund holds companies from the S&P 1500 Composite Index that have increased dividend payments for over 20 consecutive years. The fund has AUM of $18 billion and is yield-weighted, which means that stocks with higher yields have higher percentages in the portfolio. The expense ratio is 0.35%, and the dividend yield is 2.86%.
- Vanguard High Dividend Yield ETF (NYSEARCA:VYM): This fund tracks the FTSE High Dividend Yield Index, which includes U.S. companies with high dividends, excluding real estate investment trusts (REITs). This ETF is market-cap-weighted, which means companies with bigger market capitalizations are more represented. The expense ratio is 0.06%, the AUM is $37 billion, and the dividend yield is 2.82%.
- Vanguard Dividend Appreciation Index Fund ETF (NYSEARCA:VIG): With AUM of $61 billion, this ETF invests in an index of U.S. companies that have increased dividends for at least 10 consecutive years. The expense ratio is 0.06%, and the dividend yield is 1.74%.
As you can see, both expense ratios and dividend yields vary significantly for dividend ETFs. Funds with higher dividend yields often have higher expense ratios.
Higher expense ratios are usually hard to justify, however, as these funds select stocks based on rules described in prospectuses and don’t rely on any unique portfolio management skills or data.
Use Dividend Stocks to Create an ETF Alternative
One alternative to dividend ETFs is investing in a basket of individual dividend stocks. Because all data for ETF holdings is public, you can replicate their holdings and perhaps even do better. This can not only help you save on fees but also grant you full control over your investment portfolio.
The general approach to building a portfolio of dividend stocks involves three steps:
- Research: The goal is to select stocks with attractive dividend yields at reasonable prices. This might include both high-yield stocks like real estate investment trusts (REITs) and more expensive Dividend Aristocrats, which are stocks that have posted at least 25 consecutive years of dividend growth.
- Diversify: Buy a portfolio of stocks from different sectors and industries to increase your chances of getting dividends in any economy. You don’t have to have too many. Warren Buffett’s mentor, Benjamin Graham, argued that between 10 and 30 stocks are enough to provide optimal diversification.
- Review: Regularly review new opportunities and reevaluate your existing holdings. As a dividend investor, you don’t need to watch the stock price all the time. But you should review your stocks’ ability to continue to pay and increase dividends. The biggest red flag would be a dividend suspension or cut, unless it’s caused by a change in the economic cycle.
This approach is both more complicated and more time-consuming. Yet even small differences in lower costs and potentially higher yields have the possibility to compound over time into life-changing sums.
Even more importantly, you will know exactly what’s in your portfolio and will know how to react to different market events.
Time to Build Your Dividend Portfolio
In this article, we’ve explored what ETFs are, what makes dividend ETFs special, and how you can go about selecting one. After that, we briefly reviewed an alternative in the form of building a portfolio of dividend stocks.
While building a portfolio is not an easy task, it is a rewarding endeavor that pays for decades to come. And you don’t need to do everything on your own. If you want to find high-quality dividend stocks that could become the foundation of your portfolio, subscribe to Investors Alley’s “Dividend Hunter” newsletter.