An Income-Paying ETF

10/01/2004 12:00 am EST

Focus:

Carla Pasternak

Editor, The Income Investor

"There are now exchange traded funds that pay regular income," says Carla Pasternak, editor of High-Yield Investing. Here, she looks at a popular and fast-growing dividend-paying ETF for those seeking portfolio diversification, income, and safety.

"Exchange-traded funds, or ETFs, track the performance of a basket of stocks or bonds. They enable investors to add a large number of different investments to their portfolio in one fell swoop. That's an enormous benefit because if one bad investment happens to weigh down your portfolio, then another one may pick up the slack. In today's volatile markets, diversification can help you protect your profits and limit your losses, in both good times and bad. With an ETF, you gain the diversification offered by a mutual fund without the pain of high fees. The best news, though, for our readers is that some ETFs are now paying regular interest income. If you're looking for dividend-payers, then an ETF that lets you purchase the 50 highest yielding stocks in a single investment may fit the bill.

"Since its November 2003 launch, the iShares Dow Jones Select Dividend Index (DVY NYSE) has become one of the fastest-growing and most popular ETFs on the market. It's also the only ETF that invests exclusively in dividend-paying stocks. The fund tracks the performance of the Dow Jones Dividend Index, which includes 50 of the highest-yielding firms in the broader Dow Jones U.S. Total Market Index. To be included in the underlying index, a company must exhibit a positive five-year dividend growth rate. Meanwhile, its dividend payout ratio (defined as the percentage of earnings used to pay dividends) must be no higher than 60% for the past five years. That guideline helps ensure that each of the fund's components pays dividends that are sustainable and are likely to keep growing in the future. Real estate investment trusts are excluded from the fund because their dividends are considered less predictable than those of regular common stocks. Companies must also exhibit trading liquidity, with an average daily trading volume of at least 1.5 million shares. To maintain these strict standards, the index is rebalanced every year and each company's weighting is based on its annual dividend.

"The dividend payment paid out by the ETF rises and falls with the payments of its underlying securities. In June, DVY paid a quarterly dividend of 48 cents, which equates to a 3.6% yield based on current share prices. That's up from a March payment of 46 cents and an initial 29-cent payment last December. In addition to dividends, the ETF offers the potential for capital gains. Their share prices move up and down with the securities they track. Since inception, the fund has returned a total of +13% (including dividends and share gains), while the overall market has remained basically flat. So far this year, DVY has delivered market-beating returns of +5.6%. The fund's low expense ratio of less than half a percentage point takes a small bite out of shareholder returns.

"We caution that the ETF is not without risk. Because of its dividend requirements, the fund is somewhat lacking in diversification both in terms of company size and sector. Almost half of its $2.6 billion assets are in mid-cap companies, while only about a third are in large-cap stocks with the balance in small-caps. When it comes to sector allocation, the fund is also heavily weighted in a few specific sectors. Almost half of DVY's assets are in financial services, mainly banks, while about 20% are in utilities. Although these sectors tend to be highly sensitive to interest rates, the fund's components have been stable dividend-payers for many years. No software, hardware, or media companies are included, and telecom only accounts for about 3% of the fund's assets. With its focus on mid-cap financial and utility stocks, DVY could add variety as well as solid income and steady returns to an income-oriented portfolio."

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