For those outside of 401(k) and other employer-sponsored retirement accounts, exchange-traded funds are rapidly taking the place of mutual funds as the product of choice for investors searching for diversification at a low price. Not only can ETFs provide a diversified vehicle for capital appreciation, they can also provide healthy and impressive dividends for the income investor. What should you know about these dividend ETFs and how do you add these products to your portfolio?

What Is a Dividend ETF?

A lot of Wall Street lingo is tough to understand for those not working at a trading desk, but on the surface, a dividend ETF is easy to understand. Just as stocks may or may not pay a dividend, ETFs are the same depending on the index they track. Take for example, the SPDR S&P Dividend ETF (SDY), which seeks to replicate the performance of the S&P High Yield Dividend Aristocrats Index.

This index is comprised of roughly 82 companies from the S&P 1500 that have increased their dividends each year for at least 25 years. Because SDY follows an index based on dividends, it might be well suited for the dividend investor since its annual distribution yield is over 3%.

An ETF doesn't have to track an index based solely on dividends in order to be a dividend ETF. The Financial Select Sector SPDR ETF (XLF) tracks a basket of companies in the financial sector with many paying little or no dividend, yet XLF still yields nearly 2%. Even broad market ETFs can provide meaningful income streams, like the SPDR S&P 500 (SPY), which pays roughly 2%.

With a large amount of ETFs paying a dividend, an investor can find a product in nearly any sector with a dividend yield with some of those yields reaching into the double digits .


Why Not Simply Purchase Dividend Stocks?

Simply put, diversification. In order to gain the diversification that comes with a dividend ETF, you would have to purchase a large amount of stocks. The SPDR S&P 500 (SPY) has 501 holdings, while the iShares Russell 2000 Index (IWM) has over 1,900. That's a lot of stocks for the individual investor or even smaller financial firms.

You would not only have to track hundreds or even thousands of stocks, you would have to rebalance your basket of securities quarterly, semi-annually or even more frequently depending on the index you're replicating. The S&P 500 is a market-weighted index and as it rebalances quarterly, your self-made ETF would have to do the same if it were tracking this index.

The other advantage to dividend ETFs is lower volatility. Because of the large amount of holdings within the fund, volatility is greatly reduced .


What's Wrong with Dividend ETFs?

Market insiders and the financial media like to label investment products as both good and bad, but in reality, it's probably more accurate to say that some products are not well suited for some investors while others are a better fit. For investors looking for the simplest products, individual dividend-paying securities are likely the most appropriate because ETFs, although simple on the surface, are sometimes complicated under the hood. We won't explore the deep complexities of ETFs, but there is one potential downside worth mentioning not only with dividend ETFs but all ETFs.

ETFs are designed to track an index, but how they accomplish this objective varies. Take a look at two emerging market ETFs. The Vanguard MSCI Emerging Markets ETF (VWO) has a three-year return of 18.66% and an annual dividend yield of 2.16% .

The iShares MSCI Emerging Markets ETF (EEM) has a three-year return of 14.27%and a yield of only 1.66%. Although not largely dissimilar, comparing multiyear performances to the broader category and the actual index reveals results that are significantly different. Consider this question: which countries would you include in your emerging markets index and at what weighting? Should South Korea or Taiwan have a place in the fund or would they be better suited in an ETF holding developed countries?

How about technology? Technology is a vast and varied sector and the makeup of an index could cause one fund to perform quite well while another might perform poorly despite tracking the same sector. With the vast amount of choices available to you, examining the holdings of each fund while also considering the expense ratio should be near the top of your research criteria.


How Should I Use Dividend ETFs in my Portfolio?

Investing entirely in ETFs is a strategy growing in popularity as ETFs continue to rapidly gain market share, though most portfolios aren't entirely dedicated to these products.

Using a dividend ETF to gain a relatively stable source of income is an obvious choice and, as stated earlier, the vast diversification of dividend ETFs versus traditional stock purchase is a major advantage. But there's another way to use these products to your advantage: dividend ETFs are a great way to decrease overall portfolio volatility .

Take, for example, the iShares Dow Jones U.S. Utilities Sector Index Fund (IDU), which seeks to replicate the performance of the Dow Jones Utility Index. Investors know that the utilities sector generally offers two key advantages: yield and stability. IDU has an annual dividend yield of 3.41% and a beta of only 0.85. Finding dividend ETFs in defensive sectors can reduce overall portfolio volatility but they also serve as an easy way to increase defensiveness during times of market downturns.


Not Just A Check

Dividend ETFs don't only serve as a means of reliable income; growth investors use these products to reduce portfolio volatility and protect capital in times of market uncertainty.

Don't take the path of the inexperienced investor and look only at the dividend yield. Dig deeper and see how each name in the space has performed relative to their peers and the index they follow.

Disclosure: No positions at time of writing.

Related Articles
  1. Investing News

    Latest Labor Numbers: Good News for the Market?

    Some economic numbers are indicating that the labor market is outperforming the stock market. Should investors be bullish?
  2. Budgeting

    Just the Right Book Review: Is It Worth It?

    Take an in-depth look at Just the Right Book, a subscription service that delivers personalized book selections based on your reading history and preferences.
  3. Investing News

    Stocks with Big Dividend Yields: 'It's a Trap!'

    Should you seek high yielding-dividend stocks in the current investment environment?
  4. Investing News

    Should You Be Betting with Buffett Right Now?

    Following Warren Buffett's stock picks has historically been a good strategy. Is considering his biggest holdings in 2016 a good idea?
  5. Products and Investments

    Cash vs. Stocks: How to Decide Which is Best

    Is it better to keep your money in cash or is a down market a good time to buy stocks at a lower cost?
  6. Investing News

    Who Does Cheap Oil Benefit? See This Stock (DG)

    Cheap oil won't benefit most companies, but this retailer might buck that trend.
  7. Economics

    Can the Market Predict a Recession?

    Is a bear market an indication that a recession is on the horizon?
  8. Budgeting

    The Honest Company Bundles Review: Are They Worth It?

    Learn more about The Honest Company and its bundle subscription services, which deliver discounted diapers, formula and other baby products to your doorstep.
  9. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
  10. Stock Analysis

    Performance Review: Emerging Markets Equities in 2015

    Find out why emerging markets struggled in 2015 and why a half-decade long trend of poor returns is proving optimistic growth investors wrong.
RELATED FAQS
  1. Should mutual funds be subject to more regulation?

    Mutual funds, when compared to other types of pooled investments such as hedge funds, have very strict regulations. In fact, ... Read Full Answer >>
  2. Do ETFs pay capital gains?

    Exchange-traded funds (ETFs) can generate capital gains that are transferred to shareholders, typically once a year, triggering ... Read Full Answer >>
  3. How do real estate hedge funds work?

    A hedge fund is a type of investment vehicle and business structure that aggregates capital from multiple investors and invests ... Read Full Answer >>
  4. Are Vanguard ETFs commission-free?

    While some Vanguard exchange-traded funds (ETFs) are available commission-free from third-party brokers, a large portion ... Read Full Answer >>
  5. Do Vanguard ETFs require a minimum investment?

    Vanguard completely waives any U.S. dollar minimum amounts to buy its exchange-traded funds (ETFs), and the minimum ETF investment ... Read Full Answer >>
  6. Can mutual fund expense ratios be negative?

    Mutual fund expense ratios cannot be negative. An expense ratio is the sum total of all fees charged by an asset management ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center