Lowell: The New ETF Trader

12/17/2004 12:00 am EST


Jim Lowell

Partner & Chief Investment Officer, Adviser Investments

Jim Lowell, well known to our readers for his Fidelity Investor , has developed a new and exciting product that focuses on exchange traded funds. Along with CBS Marketwatch, he has launched  The ETF Trader. Here’s a look at his new letter.

"Investors looking for income are increasingly hard pressed to find an inflation-beating yield with reasonable levels of risk. True, you can run headlong into junk bonds or REITS, but from a risk and valuation perspective respectively, you might wish you'd just banged your head against a wall. On the safest side of the income investor's risk spectrum sit Treasuries, which, as luck would have it, are the most at risk in a rising-rate environment. One option that many income investors often overlook? Stocks. Specifically, dividend paying ones. Better yet, turn to the one dividend-generating exchange traded fund.

"But before I turn there, let me quickly address the income investor who may mistakenly think that bonds are always a safe haven and that stocks aren't. In sum, I think bonds look overbought and stocks don't. Currently the S&P 500 earnings yield is 5% vs. the 10-year bond at 4%. What this tells me is that stocks are relatively cheap, and/or bonds are relatively expensive. While I'm not suggesting that income investors dump all their bonds and buy a truckload of dividend-paying stocks, I am suggesting that now -- right now -- is a good time to diversify your asset allocation and, at the same time, deliver reasonable returns and yields to your doorstep.

"One option for income that, by virtue of the fact that it's a yearling, you may not know about is the iShares Dow Jones Select Dividend Fund (DVY ASE). It's the only ETF that invests entirely in dividend-paying stocks. Its performance benchmark: the Dow Jones Select Dividend Index which invests in 50 of the highest dividend paying stocks (non-REIT) in the Dow Jones US Total Market Index. Its focus is safety first. This ETF does not invest in real estate investment trusts, because of the unpredictable nature of their dividend distributions. What passes muster? A company can be considered for the index if it has been paying dividends for five years, has a high payout ratio (dividends in relation to earnings).

"It also focuses on tax and yield advantages second. Dividends can now be passed at lower tax rates than regular income, and good yields (i.e., inflation-beating ones), being increasingly harder to find in the fixed-income market are found here. Performance is a third focus. The fund has performed well. Since its inception in November 2003 through last month's end, the fund has returned 19% while the Dow has returned 3.9%.

"The fund's makeup is comprised largely of financial & utility companies. Currently, the two top holdings are Bank of America and People's Bank, which both yield in the vicinity of 3%. Companies with high dividend payouts tend to be large established companies. Both Bank of America & People's Bank have market caps over $100 billion. Currently, the fund sports a 3% yield and a 0.40 percent expense ratio, which makes it an inexpensive offering for conservative investors looking for income. This compares to a scant 1.6% for the S&P 500.

"There are some changes in store for the fund. Dow Jones announced that on Dec. 20, the Dow Jones Select Dividend Index will expand from 50 to 100 holdings which will affect this ETF as well. This is primarily the result of more companies paying out dividends. But, there are some strategic issues at work as well. For example, Dow Jones will lower its trading requirements by allowing more companies with less trading volume to become eligible for the index. This could be seen as a negative due to the larger price fluctuation of companies with lower trading volumes; but it can also be seen as a positive as the portfolio will be more diversified with twice the amount of holdings. A yield of over 3%, and a well diversified portfolio of value-oriented stocks which, relative to bonds, sure looks like a bargain - and that's something I think every income investor can appreciate."

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