When the economy is struggling and unemployment is increasing, having a reliable source of income is more important than ever. One way to achieve this is by investing in high-income paying dividend ETFs, also known as exchange-traded funds which are a basket of stocks that track a specific market and regularly pay dividends. They are more diverse than individual dividend stocks because they invest in a market basket of stocks which provides greater diversification to minimize your risk. Most people invest in dividend stocks or ETFs because regardless if the market goes up or down, they provide predictable investment income.
How much do dividends contribute to total returns?
According to the S&P Dow Jones Indices research team, reinvested dividends represent ~32% of total returns since 1940 and ~68% of total returns since 1988!
Similarly, Hartford Funds’ recent analysis by decade shows that dividends represent a significant contribution to total returns and it becomes even greater during decades with bear markets or down economic cycles.
Extremely high-yielding dividend ETFs are normally seen as risky investments. Companies may offer temporary high dividend payouts because they need to raise capital due to challenges with their financial operations. Additionally, if the company’s revenues drop, investors risk losing both their dividends and their initial investment. Alternatively, companies may offer a high dividend because there was an unexpected positive windfall from business operations and they are rewarding investors. Either way, these dividends may not be sustainable in the long-run.
Therefore, beginners should NOT chase high yields, but to focus on total returns! The time horizon also matters. If you are an investor nearing retirement, you may depend on a higher dividend and more frequent payout to pay your bills. Whereas, if you are an investor with a longer time horizon, you may want investments that are more focused on total returns and dividend growth rather than over-emphasizing high yields.
How can dividend ETFs be compared?
Investors should compare dividend ETFs by dividend yield, payout ratios, track record, dividend growth, relative segment performance, portfolio quality and expense ratio.
Each of these metrics are further defined below for ease of reference:
1. Dividend Yield: Is the annual dividend paying at least 4% yield?
2. Dividend Payout: How much does the dividend represent of total returns (dividend + price appreciation)?
3. Track Record: Does the fund have a consistent payment record even during down economic cycles?
4. Dividend Growth: Has the fund increased its payout annually, returning money to shareholders over time?
5. Segment Benchmark: Does the specific fund outperform its segment benchmark?
6. Portfolio Quality: How diverse are the underlying positions so that there is low concentration risk?
7. Expense Ratio: Is this a low-cost index fund, which is measured by its expense ratio?
We’ve conducted a preliminary analysis of the top 8 high-yield dividend ETFs based on assets under management greater than $700M based on the criteria above.
As part of this exercise, we applied a simple weighting methodology to each criteria, assuming we are a conservative investor with a longer time horizon to retirement:
- Annual Dividend (x2) – ETFs with annual dividend payouts of greater than 4% were rated higher
- Net Annual Dividend-to-Annualized 5-Year Total Return (x2) – ETFs with annual dividend payouts that represented less than 50% of total returns demonstrated a balanced earning potential
- Outperform Benchmark 5-Year Annual Total Return (x2) – ETFs that outperformed the segment benchmark may suggest higher-performing funds
- Track Record (x1.5) – ETFs that have been on the market longer, especially those that have at least 10 years of payout history were rated higher
- Dividend Growth (x1.5)– ETFs that have higher than an average y/y dividend growth of 34% were rated higher signaling their focus on increasing shareholder value over time
- Low Expense Ratio (x1) – funds with less than 0.1% in fees were rated higher
- Low Concentration Risk (x1) – the higher the number of underlying positions as well as representation from multiple industry sectors, the lower the concentration risk
Among dividend ETFs, which ETFs ranked the highest?
According to our analysis, Vanguard’s VYM, Charles Schwab’s SCHD and Blackrock’s iShares Select Dividend ETF (DVY) ranked higher than other ETFs.
This prioritization is primarily attributed to strong total returns, track record of sustained payouts as well as growing dividends over time. Additionally, these dividend ETFs have relatively low expense ratios and are extremely diverse. Please note that based on your individual financial priorities and time horizon, the criteria and weighting may vary. As a result, you may end up with a different set of prioritized dividend ETF funds.
Disclaimer: My wife and I own both VYM and SPYD. As early retirees, we have pursued a hybrid strategy of prioritizing total returns, diversification and income to offset inflation. SPYD is relatively low cost and pays a higher dividend yield of 4.74%, but is more concentrated in 81 positions primarily in financials and energy.
In conclusion, investing in dividend ETFs can provide a reliable source of income to stretch your dollar and provide more cash flow predictability during an economic recession. Dividend ETFs are also generally less risky than individual dividend stocks. If you don’t need part or all of the income in the short term, make sure you reinvest the dividends so that you can benefit from compounding, further enabling you to grow your income! Hope this post was helpful and invest safely.
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