2 Well-Diversified Income ETFs

05/16/2012 11:15 am EST

Focus: ETFs

These two exchange traded funds take different strategies for finding solid dividend yields that have a proven track record of growth, writes Timothy Strauts of Morningstar ETFInvestor.

The market rallied sharply in early 2012, as compromise in Europe over the sovereign debt crisis eased fears of another global financial crisis. The market’s relative calm has been accompanied by improving economic data, particularly employment and housing-related numbers. Since the strong rally, US stocks are not as undervalued as they were a few months ago.

With the stock market fairly valued according to several different valuation metrics, it may make sense for investors to consider dividend investing. If stocks are less likely to produce large capital gains going forward, income investments should become a more important piece of your portfolio.

Guggenheim Multi-Asset Income (CVY) takes a different approach from the typical dividend ETF. Instead of just owning a collection of US dividend stocks, CVY adds an allocation to foreign dividend stocks, closed-end funds, master limited partnerships, preferred stocks, Canadian royalty trusts, and REITs.

By diversifying income vehicles, CVY aims to improve returns by offering a higher dividend yield than the competition. CVY has a 12-month yield of 5.1%, which is substantially higher than that of the largest dividend stock ETF, iShares Dow Jones Select Dividend (DVY), with a 12-month yield of 3.37%.

A wealth of evidence and research supports dividend investing. For one, dividends, or the promise of them, are the soundest reason to buy equities—any other rationale relies on Ponzi thinking.

Dividend investors also buy the main driver of historical stock returns: income today instead of the promise of capital appreciation tomorrow. According to the excellent Credit Suisse Global Investment Returns Sourcebook 2011, from 1900 to 2010 the US stock market experienced 6.17% annualized real growth.

About 4.24 percentage points of the market’s return came from dividends, 1.37 percentage points from real per-share dividend growth, and a paltry 0.56 percentage points from price-dividend expansion (also known as the speculative return).

Some academics, citing the Modigliani-Miller theorem, argue that it doesn’t matter whether a company pays a dividend. A company that holds back earnings, they claim, clearly has good investment opportunities to further grow profits.

However, a 2003 paper by Robert Arnott and Clifford Asness showed that, contrary to common wisdom, higher dividend payouts predicted increased earnings growth for the aggregate US stock market. Other studies found the same relationship abroad and in individual companies.

The broad sweep of evidence strongly supports the idea that dividends enforce discipline on managers who may otherwise binge on empire building. Further poking holes in efficient-market thinking is the fact that dividend-paying stocks have outperformed non-paying stocks in almost every market studied, with lower volatility.

Investors buying a dividend index are betting that the market will pay too much for growth stocks. It’s a bet that has paid off handsomely throughout history, in the US and abroad. Even armed with this knowledge, investors have fallen for bubbles over and over again.

Growth stocks’ persistent underperformance across time, geography, and institutional configurations suggests that human nature is the dominant hand behind bubbles. We’d be comfortable taking the dividend index’s contrarian bet for the long run.

Because CVY’s stated benchmark is DVY, it makes sense to compare them. Over the past five years, CVY has returned an average of 2.1% per year, which handily beats DVY’s 0.8% loss over the same period.

Even though CVY is the more diversified fund, it took on more risk, with a standard deviation 4% higher than DVY’s. The increased diversification of CVY has improved returns, but comes with higher risk.

The S&P 500 yields about 2% and historically has grown real per-share dividends by about 1% to 2% annualized. If you add in share buybacks, a hidden boost to yield, equity investors are facing a prospective long-run 4% to 5% real return. In this low expected return environment, the high consistent yield of CVY is very attractive.

Portfolio Construction
CVY tracks the Zacks Multi-Asset Income Index, which selects a diversified group of securities with the potential to have a yield in excess of and outperform the Dow Jones US Select Dividend Index. The index contains 125 to 150 securities that are weighted on a liquidity basis.

The actual selection methodology is proprietary, so we don’t know exactly how Zacks picks securities. In general, the index holds approximately 50% US common stocks, 10% international stocks, 10% closed-end funds, 10% master limited partnerships, 10% preferred stock/Canadian royalty trusts, and 10% REITs.

The fund charges 0.73%, which is above average for a dividend-focused strategy. CVY’s unique holdings help justify this higher fee level.

Our favorite pure dividend stock portfolio is Vanguard Dividend Appreciation ETF (VIG), which eschews yield seeking and instead screens for companies that have grown their dividends consistently over the past ten years and can sustain them.

Mergent, VIG’s index creator, doesn’t disclose its proprietary selection methodology, but it seems to hone in on companies with strong balance sheets and solid earnings growth. The result is among the highest-quality portfolios out there. However, the quality focus means VIG’s yield usually just paces the S&P 500’s. VIG levies a 0.18% expense ratio.

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