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The Hazards of Dividend-Stock ETFs

Stan Luxenberg

NEW YORK ( TheStreet ) -- Searching for reliable income, investors have been pouring into exchange-traded funds that hold large-cap dividend stocks.

Favorite choices include iShares Dow Jones Select Dividend , which yields 3.3%, and SPDR S&P Dividend , with a yield of 2.8%.

But the funds may not be as safe as many shareholders think. The problem is that dividend stocks have rallied sharply. Now many command premium prices.

In a downturn, the dividend stocks could sink sharply. The iShares dividend fund could be particularly vulnerable because it emphasizes a few hot sectors, including utilities and consumer staples, traditional income sources.

In the past, utilities and consumer stocks often sold for below-average prices. Shareholders figured that the companies were mature businesses that could only grow slowly. But lately the dividend payers have been bid up by investors who sought safe choices.

According to Morningstar, utilities are forecast to increase earnings at a 5% annual rate. Yet the sector sells for a forward price-earnings ratio of 17.1, while the S&P 500 commands a P/E of 14.6. Information technology, which is expected to grow 12.7% annually, has a P/E of only 14.5. Financials, which should grow at an 8.9% rate, have a P/E of 11.3.

To avoid overpaying, cautious investors should consider mega-cap funds, such as Guggenheim Russell Top 50 Mega Cap and Vanguard Mega Cap . The mega-cap funds, which invest in the biggest stocks, yield around 2.1%. "The mega-caps are attractively valued," says Michael Rawson, a Morningstar analyst.

The mega-cap funds have remained relatively cheap because they have big stakes in undervalued sectors, such as technology. While the iShares dividend fund has 30% of assets in utilities, the Guggenheim mega-cap fund has nothing in the sector at all.

Guggenheim has 22.6% of assets in technology, compared to 6.8% for the iShares dividend fund. The Guggenheim mega-cap fund's portfolio has a multiple of 14.2 and earnings growth of 8.8%. That looks appealing compared to the dividend fund, which has a multiple of 14.7 and earnings growth of 6.9%.

Most investors already own at least some mega-cap stocks. Broad market ETFs such as SPDR S&P 500 have big stakes in such mega caps as Exxon Mobil and International Business Machines . But this could be a time to overweight the group by adding a mega-cap fund.

Most often investors should not necessarily emphasize mega-caps. Many academic studies have shown that large stocks trail small ones over long periods, and mega-caps do particularly poorly. But there are cycles when mega-caps shine.

During the late 1990s, mega-caps led small-caps and mid-caps as investors gravitated to giant technology stars. Then the trend reversed, as small stocks moved into the lead during the downturn that began in 2000.

The giant stocks fared relatively well during the market collapse of 2008 when investors preferred familiar blue chips. But since then, mega-caps have trailed.

During the past three years, the Guggenheim mega-cap fund has returned 16.8% annually, compared to 18.4% for the S&P 500.

The definition of mega-cap varies. Some funds focus on the 50 largest stocks, while others include 100 or more names.

The Guggenheim fund holds the 50 biggest stocks in the Russell 3000 index. The average market capitalization of the portfolio is $166 billion. Exxon Mobil is the biggest holding, accounting for 6.0% of assets. Apple is 5.7%. Other stocks in the top 10 include Microsoft , General Electric , and Chevron .

Holding about 300 stocks, Vanguard Mega Cap has an average market capitalization of $75 billion. Because it owns some smaller stocks, Vanguard has outperformed its Guggenheim competitor in recent years when mega caps have trailed. But when the very biggest companies move into the lead again, Guggenheim should be hard to top.

At the time of publication, Luxenberg had no positions in stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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