Can Dividend ETFs Beat The Bear?

• By Simon Maierhofer
• On 3:22 am EST, Wednesday December 3, 2008

Like a cat thrown in cold water, this stock market has humbled many investors. As recent as last year, with the Dow climbing to an all time high of over 14,000, dividends were a moot point. After all, who needs dividends if your stock holdings are up 20% or more?

A look at behavioral patterns reveals that investors are willing to forgo a dividend payout in return for capital gains during economic expansion. On the flip side, when investors are fearful they demand money (dividends) up front.

Warren Buffett appreciates the value of dividends. Even though Goldman Sachs (NYSE: GS - News) has tumbled since Buffett's investment in the company, his preferred shares collect a 10% annual dividend (read related article 'Has Warren Buffett Lost His Touch' here).

More than 'just' dividends

Dividends are more than merely a cash payment happily received by investors. Historic dividend yields are reliable indicators when assessing stock market valuations. Whether you are a dividend investor or not, learning a bit more about the impact and ramifications of dividend yields will make you a more seasoned and savvy investor.

                                        

Are dividend ETFs an effective way to hedge against market risk? What do dividend yields indicate about the current valuation of the market? How do historic dividend yields correspond to market bottoms?

The beauty of dividends is that unlike Price/Earnings ratios (P/E), where the 'P' is fact and the 'E' negotiable, dividends cannot be manipulated. Either cash is paid to shareholders or it is not.

The current dividend yield of the S&P 500 (AMEX: SPY - News) is 2.86% while the Dow Jones (AMEX: DIA - News) pays 3.24%. The once popular Nasdaq (Nasdaq: QQQQ - News) yields only 0.45%.

ETF structure matters

While most Exchange Traded Portfolios are organized as Regulated Investment Companies (RICs) under the 1940 Act, the above three (SPY, DIA, QQQQ) are registered as Unit Investment Trusts (UITs). UITs do not allow reinvestment of dividends. The UIT structure creates a cash drag as dividends have to be held in a non-interest bearing account until distributed quarterly. The RIC structure on the other hand allows reinvestment of dividends within a fund.

A close look at performance

The iShares DJ Select Dividend ETF (NYSEarca: DVY - News) and First Trust Value Line Dividend Index (NYSEarca: FVD - News) have been around long enough to compare their performance against the S&P 500 during bull market years (Nov. 2003 - Oct. 2007) and bear market years (Oct. 2007 - Nov. 2008). FVD lagged the S&P 500 by over 20% and underperformed through the entire four-year bull period. DVY was ahead of the S&P 500 for most of the time but dropped in the final month of the bull market, ending up 9% lower than the S&P 500.

FVD did better over the past 13 bear months, outperforming the S&P 500 by about 9% while DVY lagged the S&P for most of the time but ended up with a 2% advantage. Other dividend ETFs like the SPDRs S&P Dividend ETF (NYSEarca: SDY - News) and the Vanguard High Dividend Index Fund (NYSEarca: VYM - News) outperformed the SPY and DVY during the recent bear market as did the PowerShares Dividend Achievers Portfolio (NYSEarca: PFM - News).

Unlike other fund families, WisdomTree approaches dividend investing from a different angle. While many dividend ETFs are market cap weighted, WisdomTree weights the underlying components according to cash dividends paid (WisdomTree LargeCap Dividend Fund, NYSEarca: DLN) or dividend yield (WisdomTree Dividend Top 100 Fund, NYSEarca: DTN).

This dividend weighted approach, even though delivering better returns than many other dividend funds, was not able to outperform the S&P 500 since the bear market started in October 2007.

All in all, there are eleven domestic ETFs that include 'dividend' as part of their job description (name), many of which are out-staged by higher yields from simple value funds (click here for a complete list of dividend and value ETFs). The Rydex S&P 500 Pure Value Fund (NYSEarca: RPV - News) boast a yield of 5.80%, the Vanguard Value ETF (NYSEarca: VTV - News) offers a yield of 4.27% with a price tag of only 0.10%.

Preferred stock ETFs are another avenue to gain exposure to high yields. The PowerShares Financial Preferred Portfolio (NYSEarca: PGF - News) currently yields 11.45%. Preferred stocks offer a little more safety than a typical stock fund. In terms of volatility, they range somewhere between stocks and bonds. Owners of preferred stock enjoy a preferred status over common stock holders. That means, if a company goes bankrupt, preferred shares get first status over those holding common shares.

Currently, you will find that the highest yieldingETFs double dip in the financial sector. Although financials pay higher dividends they come with more risk and volatility.

Take Citigroup as an example. On paper, Citi still boasts a 9.08% dividend yield. However, in exchange for accepting the government bailout, Citi was forced to cuts its dividend to one penny per share per quarter. To make matters worse, shares of Citigrougp plunged from $55 to $7. How many other companies will face the same fate?

What dividends tell us about the market - has the market bottomed?

In March of 2000, Dividend yields reached an all time low of 1.4% exactly at the same time the tech heavy Nasdaq recorded its all time high. For the first time in years, the S&P 500 Index is yielding more than 10-year Treasuries. Does this mean that the worst is over?

History shows that dividend yields have to reach a certain level before the stock market will bottom for good. The recent issue of ETFguide's ETF Profit Strategy Newsletter compares current dividend yields with historic levels to reach a surprising conclusion.

Buzz up!