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No Free Lunch: The Risks of Dividend ETFs

tlydon@globaltrend.com (Tom Lydon)

Investors trying to bolster yield in their portfolios have made dividend exchange traded funds one of the hottest investments the past two years. There is speculation Apple (NasdaqGS: AAPL - News) may announce a dividend at its shareholder meeting Thursday, which could drive further interest in the category.

However, dividend ETFs come with risks that investors need to consider before jumping in.

Since dividend funds invest in stocks they have “significant exposure to market risk,” writers Larry Swedroe at CBS MoneyWatch.

“This means they have entirely different risks than bonds, which are meant to be safe havens during difficult market periods,” he said. [Best Dividend ETFs]

Although dividend ETFs may “provide higher yields than bonds in this current environment, keep in mind what would likely happen if the market heads south again,” Swedroe added. “Not only would the value of the stocks drop, but the companies may choose to trim or even eliminate their dividends. Certainly, that’s what we saw in 2008.” [Bubble in Dividend ETFs?]

Low bond yields and a preference for conservative equity strategies have resulted in investors piling into dividend ETFs.

Stock funds as a group saw net redemptions last year, but those focused on dividends gathered about $3 billion, according to Morningstar. Meanwhile, dividend ETFs took in $14.3 billion.

“Higher valuations may limit dividend payers’ upside, but there’s reason to think they still have room to run. First, bond yields are likely to remain low until at least 2014 (if the Fed gets its way), so income-producing stocks will remain one of the only places to find meaningful yield,” the investment researcher said.

Dividend ETFs outperformed the market last year but have been lagging in 2012 with investors favoring riskier sectors. “Investors should also remember that dividend-paying stocks don’t always behave like other stocks,” the Wall Street Journal reports.

Also, Vanguard Chief Economist Joe Davis cautions bond investors against blindly running to dividend stocks in search of yield. If investors substitute dividend-paying stocks for bonds to generate greater income, “the final result is a more aggressive and more stock-heavy strategic asset allocation” because stocks are riskier and more volatile than bonds, he said.

“If you hope to gain more income by increasing your allocation to higher-yielding bonds or dividend-paying stocks, you should be aware that your portfolio volatility will likely increase as a result,” Davis wrote at the Vanguard blog.

SPDR Dividend ETF (NYSEArca: SDY)