5 ETFs for the Dividend Investor

Put more cash in your pocket investing in these dividend-focused exchange-traded funds.

If you’re looking to build a portfolio around companies that pay dividends, you’ll find a treasure trove of choices in exchange-traded funds. At least 35 ETFs follow a dividend-focused strategy, investing in income-paying stocks of large companies and small ones, in U.S. corporations as well as firms based overseas. And that doesn’t include the ETFs that invest in real estate investment trusts and master limited partnerships, two groups that tend to offer high yields.

It’s no surprise that dividends have returned to their rightful place as a key building block in investor portfolios. Historically, dividends have accounted for more than 40% of the stock market’s returns. They represent real cash in your pocket now. And after watching their paper profits go up in flames twice during the past decade’s two bear markets, burned investors realize that dividends are the only sure profits they can count on from stocks.

More than that, dividend-paying companies are among the most stable and least volatile companies on the market. The constant need to pay cash means these companies are consistently profitable and have management teams capable of keeping them that way.

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Yield -- a stock’s annual dividend rate per share divided by its share price -- is always an important consideration when building a dividend-based portfolio. SPDR S&P 500 (symbol SPY), an ETF better known as the Spider, tracks Standard & Poor’s 500-stock index; as of December, the ETF yielded 1.8%. SPDR Dow Jones Industrial Average ETF (DIA), formerly called the Diamonds, yielded 2.5%. If you can get yields of this amount from the key market benchmarks, you should eliminate any fund that pays less.

One of the best strategies is to invest in companies that increase their dividends on a regular basis. Firms that boost their payouts regularly are almost always those that generate steadily rising profits and are run by managers who are confident about the future.

Our top choice is SPDR S&P Dividend ETF (SDY), which tracks the S&P High-Yield Dividend Aristocrats Index. It holds 60 companies from the S&P 1500 Index that have lifted their dividends at least 25 straight years. Most are high-quality, large-capitalization stocks that trade at reasonable prices.

Over the past five years, SDY returned 3.3% annualized, beating the S&P 500 by an average of one percentage point per year. In 2010, the ETF returned 16.4%, compared with the S&P’s 15.1% rise. SDY’s annual expense ratio is 0.35%. (All returns are through December 31.)

Because of their potential for faster growth, emerging markets should produce greater returns than the U.S. market. But instead of buying an ETF that tracks the benchmark MSCI Emerging Markets Index, look at the WisdomTree Emerging Markets Equity Income Fund (DEM). It holds the highest-yielding stocks in the WisdomTree Emerging Markets Dividend index, which tracks about 1,000 dividend-paying companies with a market capitalization of $200 million and up on major exchanges in 19 developing nations.

The ETF holds about 300 stocks, representing the 30% with the highest yields in the index. The ETF gained 7.9% annualized over the past three years, outpacing the MSCI Emerging Markets index by an average of eight points per year. The fund yields 3.1%, far topping the emerging-markets index’s yield of 2.2%. Companies from Taiwan and Brazil make up 38% of the fund, while there’s no exposure to China or India. The ETF’s expense ratio is 0.63% a year.

Although emerging markets are hot, it’s good to have a foothold in the broader world. First Trust DJ Global Select Dividend Index Fund (FGD) tracks an index of 100 high-yielding stocks from the developed world. Split between large-cap and midcap stocks, 26% of the portfolio comes from North America, 33% from Western Europe and 33% from Asia. Australia and the U.S. each account for 17% of the portfolio’s country exposure, with the United Kingdom at 11.9% and Canada at 8.6%.

With 51% of the portfolio tied up in financials at the beginning of 2008, the First Trust fund was one of the worst-performing global-stock ETFs that year, plunging 50%. In 2009, the fund rebounded, surging 64%. Because of the big decline in their stock prices during the bear market and the removal of stocks that had eliminated or cut their dividends, financials now account for just 20% of the portfolio. The telecommunication services sector, accounting for 24% of assets, is now the ETF’s biggest sector. The ETF, which yields 4.5%, returned 12.3% in 2010. It charges a fee of 0.6% annually.

For some people, yield is everything. Those kinds of investors may prefer iShares S&P U.S. Preferred Stock Index Fund (PFF), which tracks 220 preferred stocks from 44 U.S. companies and yields a succulent 7.4%. About 90% of the fund’s assets are in preferreds issued by financial companies, which means the fund is not diversified across many sectors and is highly concentrated in an industry that some still consider to be on shaky ground. Preferred stocks tend to behave more like bonds than common stocks, rising in value when interest rates fall and declining in price when rates rise. The ETF’s three-year annualized gain of 6.8% beats the S&P 500’s return by an average of 9.7 points per year. The ETF charges 0.48% annually.

A high-yielding ETF that offers more appreciation potential is Guggenheim Multi-Asset Income ETF (CVY). The fund holds 120 securities, including U.S. common stocks, preferred stocks, real estate investment trusts, master limited partnerships, closed-end funds and foreign stocks that trade in the U.S. as American depositary receipts. (MLPs are publicly traded companies -- usually involved in real estate or natural resources -- with the tax benefits of a limited partnership. A closed-end fund is a fund that issues a set number of shares in an initial public offering and then trades like a stock.)

Financial companies and utilities make up 38% of the Guggenheim portfolio. “With less exposure to traditional dividend areas, this mix could help not just yield but total return,” says Christian Magoon, chief executive of Magoon Capital, an ETF consulting firm in Chicago. The Guggenheim ETF, which yields 4.8%, returned 1.5% annualized over the past three years, outperforming the S&P 500 by 4.4 points per year. In 2010, the fund gained 17.6%, edging the index by 2.5 points. The ETF’s annual fee is 0.6%.

Contributing Editor, Kiplinger's Personal Finance