Dividend ETFs - Cash Cows Or Trojan Horses?

• By Simon Maierhofer
• On 12:14 pm EDT, Tuesday March 24, 2009

Talk about a bait-and switch strategy: Juicy dividend yields have been enticing investors to load up on high yield dividend ETFs while falling prices quickly eclipse the short-lived dividend advantage.

As the market hit rock-bottom, some dividend ETFs actually paid 20% and more. The PowerShares Financial Preferred Portfolio (NYSEArca: PGF - News) still pays a whopping 19.93%.

At first glance, dividend ETFs seem like a slam dunk, a no-brainer. However, what did our parents always preach? If it sounds too good to be true ...

Are double digit dividend yields too good to be true?

Contrary to many investment advisors who have been promoting dividend plays as a conservative bear market strategy, the December 18th, 2008 issue of the ETF Profit Strategy Newsletter warned investors that 'risk management is more important than dividend yield. If history is a guide, dividend yields will not be able to protect investor as the stock market slides further to manufacture higher yields' (this update was available to subscribers only).

This recommendation harmonized with our big picture outlook given to subscribers on January 15th: 'The best target for a temporary low is 6,700 for the Dow and 700 for the S&P 500. Extreme pessimistic sentiment may drive the indexes even towards Dow 6,000 and S&P 600. Once the new lows are reached, the markets should stage the biggest rally seen since October 2007. This rally should last several months and lift the major indexes by 30% or more.'

As it turns out, some of the biggest names in U.S. business have cut or eliminated dividends, choosing not to share the wealth either because they need the money now or want to build a safety cushion for later.

In fact, since the financial crisis began to snowball in September, dividend cuts exceeded $64 billion. Companies comprising the S&P 500 Index (NYSEArca: SPY - News) cut more than $40 billion (of the $64 billion) from their collective dividend stream since our above warning.

For the first time since 1983, Alcoa cut its payout, by 82%. General Electric slashed its dividend 68%, J.P. Morgan Chase, Citigroup, Blackstone Group, Dow Chemical, Motorola and Pfizer are just a few more companies that have either eliminated or reduced dividend pay.

Despite all the dividend cuts, dividend yields of ETFs have soared. How can that be?

Imagine a falling ocean tide. As the water level recedes, rocks become visible and stand out even more. Similarly, dividend yields become more pronounced as stock prices fall.

As the market meltdown took its course, the Dow Jones (AMEX: DIA - News) went on to lose more than 40% of its value since December 18th, while dividend ETFs lost between 50% and 70%.

To illustrate, in December the PowerShares Financial Preferred Portfolio (NYSEArca: PGF - News) boasted a 12.87% yield. After a 68% loss, PGF's yield reached 20% and more. As prices tumble, dividend yields increase. Even dividend flagships such as the iShares Dow Jones Select Dividend ETF (NYSEArca: DVY - News) lost more than half of their value.

A rule of thumb worth remembering

There are two rule of thumbs dividend investors need to be aware of:

1) The most volatile sectors - financials and real estate - pay the highest dividends

2) The higher the yield, the higher the risk/reward potential

In 2007, the Financial Select Sector SPDRs (NYSEArca: XLF - News) paid an insignificant yield of only 2.35%. Even though bailout recipients like Citigroup, Bank of America and JP Morgan Chase were forced to cut their dividend to 1 cent per quarter, XLF's dividend has soared to a whopping 10.16%. This quadrupling of the dividend yield was facilitated by an 80% drop in the underlying stock prices.

Real estate is another battered sector with double digit dividend yields. According to BMO Capital Markets, roughly 30% of all listed REITs have suspended, cut or switched to paying part of their dividend in company stock.

Nevertheless, broad REIT ETFs such as the iShares Dow Jones US Real Estate (NYSEArca: IYR - News), Vanguard REIT ETF (NYSEArca: VNQ - News) and SPDR Dow Jones Wilshire REIT ETF (NYSEArca: RWR - News) are paying between 11% and 13%. The iShares FTSE NAREIT Mortgage REIT ETF (NYSEArca: REM - News) clocks in at an amazing 26.95%.

Most ETFs considered 'dividend ETFs' draw a large portion of their dividend income from the financial sector. The iShares Dow Jones Select Dividend ETF (NYSEArca: DVY - News) by many considered the default option for ETF investing, boasts a 21% allocation to financials. DVY yields 12.91%. The SPDR Dividend ETF (NYSEArca: SDY - News) yields only 7.25% despite a 32% stake in financials.

Dividend yields of value ETFs have also risen to attractive levels. With a 20% exposure to financials, the Vanguard Value ETF (NYSEArca: VTV - News) and iShares Russell 1000 Value ETF (NYSEArca: IWD - News) pay close to 5%.

In response to the increased exposure to financials, WisdomTree has announced that it will de-couple two of its dividend focused ETFs from the financial sector. The WisdomTree Dividend Top 100 ETF (NYSEArca: DTN - News) will be renamed the WisdomTree Dividend ex-Financials Fund. The WisdomTree International Dividend Top 100 Fund (NYSEArca: DOO - News) will be renamed WisdomTree International Dividend ex-Financials Fund.

In expectation of the current rally, we sent a Trend Change Alert to our subscribers on March 2nd. Along with a number of different strategies, we recommended the following: 'Once the market starts to rally, dividend ETFs with a higher allocation to financials are likely to rise higher than the broad market. Some of the dividend yields are quite juicy and can help to offset timing mistakes.'

While the broad markets bounced some 20% of the March lows, our recommended ETFs are up between 25% - 50%.

While owning financials was a liability over the past 18 months, dividend ETFs with exposure to financials and real estate have proved to be a profit center since the market bottomed two weeks ago.

In short, financials, real estate and most dividend ETFs are good to own in an up market and a bad idea during a down market. For this reason it is imperative to ascertain whether this rally is the beginning of a new bull market or just another bait and switch decoy rally destined for lower lows.

Historic dividend yields at major market bottoms are one of the best indicators when it comes to identifying a range for the ultimate market bottom. Dividend yields along with P/E ratios and investor sentiment (represented by mutual fund's cash holdings) are the best composite long-term indicator.

The March issue of the ETF Profit Strategy Newsletter analyzes those three indicators in addition to the stock market measured in the only true currency, gold (NYSEArca: GLD - News). Stocks measured in gold is a front running indicator. Like a road sign, it foretells where stocks will be in the near future.

Dividend yields represent more than a cash incentive; they are a powerful indicator that has kept our subscribers out of trouble for the past year. If dividend yields speak, it behooves us to listen.

Buzz up!