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.

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