Must-know: The pros and cons of investing in dividend ETFs

What are dividend ETFs?

A dividend exchange-traded fund (or ETF) consists of dividend-paying stocks. Usually, ETFs track a dividend index. The stocks in the fund or index are selected based on their dividend yield. Some ETFs apply a general dividend strategy that covers the market as a whole. Others cover only a segment of the market.

Types of dividend ETFs

1. High dividend yield ETFs: These ETFs track high dividend-paying stocks (read Why Carter’s offers a robust dividend yield). The Global X Super Dividend ETF (SDIV) is an example.
2. Dividend aristocrats ETFs: These ETFs invest in stocks with long histories of raising dividend payments year after year (read HP’s cash flow supports steady dividends and share repurchases). One example is the SPDR S&P Dividend ETF (SDY). SDY is invested in the REIT HCP, Inc. (HCP), the telecommunication giant AT&T, Inc. (T), and the consumer company, The Procter & Gamble Company (PG).
3. Dividend weighted index ETFs: These ETFs simply use paid cash dividends as a way to weight stocks in an index instead of using market cap weighting. Their focus is on large companies that have paid the most dividends out to investors. The WisdomTree Total Dividend ETF (DTD) is an example of a dividend weighted index ETF.
4. Hybrid dividend ETFs: These ETFs combine any of the features of the first three. For example, the iShares Dow Jones Select Dividend ETF (DVY) weights securities based on their dividend yield. DVY also screens out non-liquid companies as well as those that might not have sustainable dividends.

Advantages of dividend ETFs

Dividend ETFs come with certain advantages. They

• create a revenue stream
• are widely considered safer than other investments
• offer a good diversification option
• provide return stability
• act as a tool to hedge against risk and inflation

The hindsight

Even though dividend ETFs generally succeed as hedges against inflation, the dividend yields may not outperform the inflation rate. As a result, the risk isn’t effectively hedged. Also, one or more of the dividend-paying companies in a fund’s portfolio may choose to cut their dividend, or eliminate it all together. In this case, the ETF’s revenue stream comes under threat.

Meanwhile, you can eliminate such risks relatively painlessly. Select ETFs with stocks that have either been paying dividends for a long time or have a stable dividend yield.

To learn more about protecting your investments in a rising rate environment, read our Market Realist series A key guide to positioning your portfolio for rising rates. You can also check out our YouTube video below: