The Dark Side Of Payout ETFs

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Dividend-focused ETFs are tempting when you hold them up against the insanely low yields on benchmark U.S. government debt. But that doesn't mean dividend ETFs are a good idea.

They might not even be a better idea than buying, say, a 10-year U.S. Treasury bond.

But first, some of the reasons why Treasurys currently look like such a bad idea …

Ten-year U.S. Treasury notes are at historical lows. Just look at debt slated to mature in 2022, which are yielding a positively wimpy 1.65 percent. I don't know that I'd lend money to the federal government for such a skimpy return.

And that explains why ETFs promising dividend yields are all the rage.

Take the iShares High Dividend Equity Fund (NYSEArca:HDV), which launched March 29 of last year, and currently has more than $2 billion in assets, making it one of 2011's most successful ETF launches. With a yield of 4.13 percent, that isn't too surprising.

But HDV is just the tip of the dividend-crazed iceberg, with ETF sponsors marketing such funds to steer investors away from the currently not-so-tempting Treasurys market.

FlexShares recently filed paperwork laying out plans for no less than six dividend ETFs-three focusing on the U.S., the other three global in focus. Each trio is distinguished in terms of volatility, an investment strategy that might as well scream, "Volatility kills dividend yield!" I wish them well, but really?

There's no denying dividend ETFs are sporting some mouth-watering yields-at least compared to Treasurys. For example, the PowerShares High Yield Equity Dividend Achievers fund (NYSEArca:PEY) is yielding 4.88 percent, the highest in its segment, according to IndexUniverse's ETF analytics tool.

So why would I give my money to the U.S. government, when ETFs like PEY can get me three times the yield?

What's That Dividend Really Doing?

Well, because what goes up must come down.

And with dividend ETFs, when the share price goes up, that hefty dividend yield everyone's raving about gets less attractive each time the share prices of the underlying holdings go up. So the later you come to the party, the less of a party it will be.

Which brings up another aspect of dividend ETFs that some yield-hungry investors may be overlooking:Equities are a lot more volatile than bonds. A falling stock price could readily wipe out even the sexiest yield on a dividend.

Hypothetically, if you fast-forward several months, PEY may not be yielding nearly as much, even if for now it looks attractive next to 10-year debt.

It seems that an ETF like PEY-again, with a yield of 4.88 percent-has a bit more wiggle room than a 10-year Treasury bond, since there's not likely to move down too much more when yield is already at 1.65 percent. That's even more true when-accounting for inflation-that 10-year Treasury bond is actually yielding -0.64 percent. Ouch.

Ten-year government debt didn't always yield so abysmally. The current Treasurys market is just a window of how extreme a decline in yields can get. It took a lot of buying interest to drive bond yields that far into the dirt.

Worse yet, stocks are not bonds, and thinking you could replace the income portion of your portfolio with dividend-paying stocks in an ETF wrapper just might be the height of folly.

So what's the takeaway here?

Beware the Wall Street marketing machine, and know exactly what you're getting into. Because when it comes to yield, while there's no such thing as a free lunch, there is such a thing as overpaying for your meal.

At the time this article was written, the author had no positions in the securities mentioned. Contact Hannah Tool at htool@indexuniverse.com.


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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

Referenced Stocks: HDV , PEY

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