They sound like a great idea. Exchange Traded Funds or ETFs are simple to understand, easy to invest in, and considerably manageable. ETFs are baskets of financial securities that trade on the stock exchange like traditional stocks. When you buy a unit of an ETF, you’re buying a shortcut to a diversified portfolio of stocks, bonds, or commodities. For most assets this works fine and can be a great way to diversify a portfolio. But certain strategies are simply not meant to be traded as ETFs.
Dividend ETFs are a great example.
Dividend ETFs work a little differently than traditional investment products. As the name suggests, dividend etfs are focused on dividend paying stocks. They collect a range of blue-chip companies that pay a relatively high dividend and are generally considered safe. Some of these ETFs track a dividend index – like the ProShares S&P 500 ® Dividend Aristocrats ETF which tracks the Dividend Aristocrats Index that’s been covered by this series before.
Then there are ETFs that simply collect a bunch of high-dividend stocks and create a unique index. The Vanguard Dividend Appreciation ETF (VIG) is the best example. It includes Microsoft, Pepsico, Johnson & Johnson, and Coca Cola amongst its top holdings.
Essentially, dividend etfs have been a great buy for income seeking investors since the financial crisis. The record-low interest rates have pushed people to look for yields elsewhere, and the combination of stock price appreciation and dividend income has made these ETFs attractive.
For many years after the Financial Meltdown, money was flowing into these dividend etfs. By 2015, the assets invested in these instruments had swelled to a record $100 billion.
Investing in Dividend ETFs may seem like a quick fix, but it’s not an easy road to riches. There are some issues with the way ETFs are priced and the stability of the yields that could make these a bad investment.
Let’s start with the most obvious downside – fees. A lot of Dividend ETFs now charge rock-bottom fees at 0.5% per year. For smaller retail investors this level of fees is justified. After all, if you only invest $10,000, your annual fees are around $50. Not bad for the level of diversification, management, and value you get from a well-managed ETF that probably yields a healthy return.
But if the account is much larger, the fees tend to stack up over time. At the same 0.5% annual fees, a million dollar account ends up with a $5,000 bill at the end of the year. That millionaire could have easily hired someone to spend a few hours a year constructing and rebalance the exact same portfolio for a fraction of the price.
Over time, even small fees can chew into overall returns due to compound interest. So, that’s a genuine issue for anyone with a sizable portfolio.
The other problem is the yield. For example, after the recent US election Treasury Yields in the US have jumped. The current yield on a 10-year government treasury bond (which is risk-free) is 2.45%. That seems like a low yield, but it’s actually higher than 3 of the top 10 biggest dividend etfs. Compare the Vanguard Dividend Appreciation ETF (VIG), which yields 2.11%, and you can see why this is a problem. In fact, it’s a bigger problem because the S&P 500 yields about the same at the moment. There is literally no advantage to investing in the ETF at the moment.
Dividend ETFs may also struggle to maintain their yield. Some of these ETFs hold more than 400 different stocks. Not all the stocks are likely to outperform the market and the overall yield will take a beating when interest rates rise.
This is already having an impact on dividend etfs across the country. As more rate hikes and possibly higher inflation is expected over the next few years, the risk-free rate could jump and many domestic ETFs will suffer outflows if the dividends don’t match up. Hundreds of millions and sometimes even billions of dollars are leaving dividend ETFs at the moment because of this.
Dividend ETFs were all the rage for the past eight years. As interest rate plummeted income seeking investors turned to these ETFs to bolster their cash flows. But now the tide has turned and most ETFs will struggle with higher interest rates, inflation, and lower economic growth.
There are two solutions – either construct your own portfolio or look abroad.
This blog has touched on the many ways retail investors can create their own rock solid dividend income portfolio. It may take a little bit of time and effort, but you can create a high-yielding dividend portfolio that outperforms the market as well as these ETFs. The key, it seems, is to look for dividend growth, sustainability, and avoiding over-diversification. Run a regular health check-up on your dividend stocks to see if they’re a good fit and cut them out if they aren’t.
Another option is to look abroad. Emerging markets and some European ETFs still offer great yields at low prices. SPDR S&P Emerging Markets Dividend ETF (EDIV) and iShares Emerging Markets Dividend ETF (DVYE) are good examples. They focus on high-yield blue chip stocks in countries like China, Vietnam, Russia, Poland, Brazil, and Taiwan to yield more than 5%.
Dividend ETFs were a great idea if you wanted to avoid the fall in fixed income rates over the past decade. But now the tide has turned and US dividend ETFs are failing to live upto expectations. Your best bet is to either create your own, customized dividend portfolio or look at foreign dividend ETFs that yield a lot more.