Dividend ETFs had seen a lot of interest in the past 2-3 years as investors searched for yield in the ultra-low interest environment. They fell out of favor for sometime after the taper talk resulted in interest rates inching higher.
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However as investors are now getting concerned about growth pace of the economy and corporate earnings, dividend ETFs are back in focus. (Read: 3 ETFs you can love forever)
Dividends Triumph over Long Term
Dividends have accounted for more than 40% of total market returns over a long time horizon (over the past 80 years). Further, since early 1970s, S&P 500 dividend growth has outpaced inflation by 100% and by almost eight times since 2010.
At the same time, since most dividend paying companies are stable, mature companies with solid cash flows these investments provide greater stability and safety in a volatile environment and the markets are expected to continue to be volatile this year. (Read: Inside the wild ride of Biotech ETFs)
Dividends Continue to Grow at Record Pace
US companies continue to increase their dividends. 2013 was the fourth consecutive year of double-digit dividend growth, after decline seen during 2007-2009. Further, dividend increases continued their strong trend during Q1 2014.
Looking at sectors, all sectors excluding financials have recorded an impressive 56% growth in the dividend stream since 2007, thanks mainly to a massive 221% surge in technology sector dividends.
Per FactSet Dividend Quarterly, financial sector is expected to lead the dividend growth, with 17.7% DPS growth estimate in 2014 and 15.1% in 2015. The surge in dividends is a result of capital plans approval of 25 major US banks by the Fed. (Read: 3 Financial ETFs o play the bank stress tests)
Overall, dividends are expected to grow 9.9% in 2014. Most large companies have huge cash piles on their balance sheet and are in a position to increase payouts to shareholders. Further, despite recent increases, dividend payout rates are still quite low (~36%) compared to their historical average of 52%.
High Quality or High Yield?
In my view, ETFs that hold stocks with high dividend growth potential are much better for long-term investing than ETFs that focus on high dividend yielding stocks. These stocks may not be paying a huge yield now but they generally have a solid growth potential.
According to a study based on the performance of both high yielding and dividend growth stocks, over the past 85 years, dividend growth should provide about 7% average annual return over the next decade while high yield stocks will return only about half as much during the same period. Further dividend-growth companies also look more attractive in terms of valuation.
Stable, cash-rich companies that have a consistent record of increasing their dividends have outperformed the boarder market over the longer-term.
And, while the interest rates reversed their course this year, they will start rising sometime in near future, so I think that it is better to avoid ETFs that have a lot of focus on defensive (bond-like) sectors including Utilities and Telecom.
Below we present three ETFs that focus on high quality stocks with strong dividend growth potential. Further they not only have low exposure to bond-like sectors, they are also well diversified across individual companies, minimizing company-specific risks.
They have also been beating the broader market this year.
SPDR S&P Dividend ETF (SDY - ETF report)
SDY follows the S&P High Yield Dividend Aristocrats index that is comprised of highest dividend paying stocks within the S&P Composite 1500 index that have consistently increased their dividend every year at least for the last 20 years.
The fund made its debut in May 2005 and has now has $12.5 billion in AUM. It has 95 securities in its basket and is well diversified among them with the top holding accounting for just about 3% of assets.
The ETF is dominated by financials stocks currently, which account for 22% of assets, followed by Consumer Staples and Industrials.
It charges an expense ratio of 35 basis points and sports a dividend yield of 2.3% currently.
WisdomTree LargeCap Dividend Fund (DLN - ETF report)
DLN is based on the WisdomTree LargeCap Dividend Index—a fundamentally weighted index that is comprised of 300 largest companies in the WisdomTree Dividend Index, weighted by proportional share of cash dividend that each component is expected to pay in the coming year.
Top holdings currently are Exxon Mobil (3.4%), Apple (3.3%) and Microsoft (3.2%). Looking at the sector allocation Information Technology takes the top spot (16%), followed by Consumer Staples (15%) and Financials (14%).
The fund has a dividend yield of 2.4% and charges annual fee of 28 basis points. Launched in June 2006, it has managed to attract $1.8 billion in assets so far.
FlexShares Quality Dividend Index Fund (QDF - ETF report)
The ETF uses a proprietary model that includes factors like profitability, management and cash flow. Firms are selected for inclusion in the index based on expected dividend payments and long-term capital growth potential.
Financials currently take the top spot with about 18% of assets, followed by Information Technology (18%), and Energy (10%). Top holding Wells Fargo accounts for just 3.7% of the asset base.
QDF has a nice dividend yield of 2.5% while the expense ratio is modest at just 38 basis points.
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