By Christian Magoon
Investing in companies that pay dividends has historically been a popular and profitable strategy. Indeed, close to 50% of the S&P 500's total return has come from dividends. Dividends not only provide an attractive source of return but they also offer investors a slight cushion to market downturns. Dividend investing has become even more popular since the qualified dividend tax rate was reduced to just 15% via the Bush tax cuts. This incentive was akin to a Cyber Monday deal when compared to paying income tax rates on dividend income. Now the qualified dividend tax rate may be on the chopping block due to the U.S. budget deficit and investors in dividend stocks and ETFs could be in for a stormy journey.
Dividend ETF investors have seen healthy gains in 2012. Simply reviewing the top ten U.S. dividend ETFs by performance shows a skew toward double digit gains. Here's the top 10 list from the Index Universe ETF Data Tool:
The Vanguard High Dividend Yield ETF (VYM), the WisdomTree Equity Income ETF (DHS) and the First Trust Morningstar Dividend Leaders ETF (FDL) top the list of U.S. Dividend focused income ETFs with gains of over 12% year to date. But taking a step back and comparing these returns to the top 10 performing U.S. Market ETFs shows cracks in the dividend story. U.S. focused dividend ETFs, even with their strong absolute year, have taken a backseat to broad based ETFs. Here's the chart from Index Universe:
The PowerShares Dynamic Market ETF (PWC), the iShares Russell 300 Value ETF (IWW) and the Fidelity Nasdaq Composite ETF (ONEQ) are the leaders of a group of ten broad-based ETFs that have all outperformed the best dividend ETF. Is this just coincidence or is the weight of a significant tax increase on dividends cooling demand for dividend stocks and the ETFs that track them?
It appears that an increase on dividend taxation is likely, which is certainly not positive for dividend focused investors and is causing uncertainty around the appeal of dividend focused investments. However, there may be a silver lining for dividend ETF investors here as tax increases on all forms of income and gains appear certain. Thus tax efficient approaches to investing will become more important than ever. Dividend ETF investors will now unquestionably find themselves in the most efficient vehicle to access a basket of dividend focused securities. While that might not provide consolation to those wishing for the good old days of 15% dividend taxation, the savings will add up as the ETF turns in far more long term capital gains than short term gains.
Taxation as we know it is about to change. Dividend focused investors will likely experience a higher rate of taxation on their dividend income. It may also reduce the appeal of dividend investing, although most alternatives are likely to impacted equally. In the big picture dividend ETFs should become more attractive than ever for investors with a dividend focus. ETFs will deliver a higher level of tax efficiency to investors in relation to other vehicles like dividend focused mutual funds. This is due to the tax advantaged structure of the ETF. Thus for dividend ETF investors, the looming tax increases aren't positive but could be much worse.