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Get This Sector's Best Dividends All In One Investment

By: StreetAuthority
Posted: 4/25/2014 9:30:00 AM
Referenced Stocks:

To consistently earn the highest returns, financial advisors often recommend using a low-cost fund that tracks the S&P 500 since there's only perhaps a 30% chance of beating the index over time with actively managed investments.

#-ad_banner-#That's all well and good if you're a growth investor, but what if your goal is to maximize your dividend yield without taking any undue risk?

In that case, tracking the market definitely isn't the way to go. One of the most popular funds that does this, SPDR S&P 500 (NYSE: SPY ) , yields a meager 1.9%. And it comes with all the stomach-churning volatility you typically see in the broader stock market.

That's why income investors so often turn to sectors known for generous dividends -- like telecommunications. Stocks in this sector often boast yields well north of 3%, and many are far less volatile than the market.

The big question is which are the best ones to own?

My answer: Why not own them all through an ETF? That way, you'll be well-diversified across the sector but still able to enjoy attractive yields.

In my opinion, the #1 choice for the job is Vanguard Telecom Services ETF (NYSE: VOX ) . The $673 million fund has the type of rock-bottom expense ratio (0.14%) investors have come to expect from Vanguard. Its main rival, the $614 million iShares U.S. Telecom ETF (NYSE: IYZ ) , charges more than three times that (0.46%).

VOX also has a much better yield -- 3.8% vs. 2.7% for IYZ. And it has performed better overall, posting a total return of 87% during the past five years, compared with 79% for IYZ.

VOX tracks the MSCI US Investable Market Telecommunication Services 25/50 Index which, as its name suggests, must meet two main requirements at the end of each quarter: No single stock can make up more than 25% of the index, and the index components with more than a 5% weighting may not exceed a combined 50% of the index's total value.

Although stated in general terms, in reality these restrictions basically apply to AT&T (NYSE: T ) and Verizon (NYSE: VZ ) , by far the index's two largest holdings with weightings of about 24% each. Key features of the top five holdings, which make up 60% of the index, appear below.

Like its benchmark, VOX has a total of 30 stocks, with the bottom 25 holdings accounting for 40% of assets. The fund has an average market cap of $21.5 billion, somewhat smaller than the category average of $30.1 billion. This is because VOX is one-quarter small stocks, compared with the category average of just 7%.

Because they don't yet have the financial wherewithal, these small firms often don't pay dividends. This doesn't affect VOX's yield much, though, because it's dominated by AT&T and Verizon, and their dividends are secure and growing.

What's more, the portfolio doesn't contain an excessive amount of small stocks, and the ones that do offer payouts often have decent or even very high yields -- like Consolidated Communications (Nasdaq: CNSL ) , a $788-million local, long-distance, and internet provider yielding 7.9%. IDT Corp. (NYSE: IDT ) , a local, long-distance and wireless carrier with a $373 million market cap, yields a solid 2.1%.

You'd think a higher-than-average small-cap allocation might make VOX more risky, though that hasn't been the case because the portfolio is tilted toward value stocks. As a result, it has been nearly 20% less volatile than the overall telecommunications services category during the past five years. Yet its price performance over that period ranks it in the category's top 20%.

By comparison, main rival IYZ's five-year price performance only places it in the middle of the pack. The fund was about as volatile as the overall category during that time, too.

It's easy to imagine some investors being tempted to conclude they might as well just buy AT&T and/or Verizon and be done with it, but that would be a mistake, in my view. While both have higher yields than VOX, they've lagged behind the fund significantly in total return, delivering about 40% and 65%, respectively, during the past five years.

VOX should continue to substantially outpace AT&T and Verizon because of its meaningful exposure to smaller companies with the potential both to grow faster and initiate or increase dividends. The latter is a distinct possibility because some of the smaller firms in the portfolio have been getting out from under debt and increasing cash flows.

The smaller players are also looking to improve their competitiveness, cost structures, and profitability through M&A. Plenty of this has been going on already in recent years, and it's likely to result in more telecom firms with greater dividend-paying ability going forward.

Risks to Consider: The telecom services industry is extremely competitive. Sprint (NYSE: S ) , T-Mobile (NYSE: TMUS ) and other firms battling for market share could resort to a price war that hurts the entire industry and hinders dividend growth.

Action to Take --> Vanguard Telecom Services ETF is the best way to garner dividends from the domestic telecom services industry in the long-term. Since the fund lacks direct international exposure, investors seeking worldwide diversification may want to consider another ETF -- iShares Global Telecom (NYSE: IXP ) . The fund has a nice yield (3.5%), but its expense ratio is higher (0.48%) and it has lagged VOX's performance by a wide margin in recent years.