Starved for income? Hungry investors hunt dividend ETFs

NEW YORK(Reuters) – Rock-bottom interest rates may be great for lots of people – but not for savers.

With a brand-new quarter-point rate cut from the Federal Reserve and ten-year government bonds yielding 1.84%, there is almost nowhere for them to go. That is why dividend exchange-traded funds (ETFs) have been grabbing investor attention.

The most prominent names in the space include the $47.8-billion Vanguard Dividend Appreciation, the $34.8-billion Vanguard High Dividend Yield, the $18.9-billion SPDR S&P Dividend and the $17.8-billion iShares Select Dividend.

Caveat emptor, though. In the dividend world you need to be cautious and understand what exactly you are buying. A few pointers:

* Not all dividend strategies are alike.

Novice investors might assume that all dividend-oriented funds are similar. Not so. In fact the differences from one fund to the next can be “enormous,” said Dave Nadig, managing director of independent news and analytics site ETF.com.

For instance: Some funds screen purely for high yield, while others screen for dividend growth. Those two strategies are going to give you very different underlying portfolios.

In particular, hunting for yield alone is a risky game to play – some companies may offer sky-high dividends because they are in deep trouble. Meanwhile dividend “growth” doesn’t necessarily mean high overall payouts; VIG, for instance, offers a modest 1.77% yield, which may not be quite what you were hoping for.

The point: “Really understand what’s under the hood,” Nadig said.

* Dividend ETFs are not bonds.

Many investors think of dividend-paying equities as bond proxies – a way to generate some income, while still enjoying the upside potential of stocks. They are also seen as a relatively safe portion of the stock market, as big, blue-chip companies are typically well-positioned to weather downturns.

But make no mistake, these are equities we are talking about. That means there is downside exposure, and you will be assuming much more risk than if you simply stuck to Treasuries.

“If the Dow takes a dive of 30%, guess what?” said Tom Roseen, head of research services for fund analysts Lipper at Refinitiv. “Your equity ETF is likely going to take a dive, too.”

* Understand payout schedules.

Dividend ETFs pass along yield, but on their own schedule. They essentially collect the dividends of the underlying securities, and then most set a quarterly date for payout. That may come in the form as cash, or as reinvestment in shares of the fund, depending on the ETF. Read the prospectus for details.

You can plow the cash back in on your own through your brokerage via dividend reinvestment programs (DRIPs), which can be a powerful tool for long-term returns. So powerful, in fact, that you may need to think about rebalancing down the road, lest your portfolio becomes overly skewed toward equities.

* Look abroad.

American companies have actually become quite stingy when it comes to dividends, so you may want to look overseas.

In emerging markets “you can find yields like 4-5-6%,” Nadig said.

One suggestion: Cambria’s Emerging Shareholder Yield, with its basket of almost 100 holdings and 3.6% yield. “Their well-managed, diversified approach is something that a lot of investors could benefit from,” Nadig added.

* Remember the taxman.

Generating cash flow is great – but as always, Uncle Sam will want a taste. If your ETFs are in a tax-deferred retirement account, not to worry yet. But if they are in a regular brokerage account, then tax implications come into play.

The dividends you receive will either be qualified or non-qualified, depending on factors like how long stocks were held by the fund. If non-qualified, dividends are subject to ordinary income tax rates. If qualified, they are subject to capital gains tax rates, which are lower; those depend on household income, but typically knock you 15%.

* Yield is one factor among many.

Yes, yield is a sexy top-line number. But there are other important attributes to keep in mind as well, such as “consistent return, expenses, total return, and preservation of capital,” said Roseen.

Good thing Lipper ranks all such funds, with five being its highest grade in any given category, and a few getting fives across the board. One Roseen mentions: SPDR International Dividend, with its eye-catching 4.34% yield.

Do that due diligence, and no matter what the economy or stock market does, dividend ETFs will be slipping a little extra cash in your pockets for many years to come.