3 Ways to Evaluate Dividend ETFs

Last year's stubbornly high inflation and associated market volatility prompted many investors to seek out additional ways to generate returns. One popular choice was dividend-focused exchange-traded funds (ETFs), which raked in $69.7 billion in net inflows in 2022.¹ 

Some investors find dividend-paying stocks attractive, in part, because their income potential may help offset any decline in their share price, which could bolster their total returns. Bundling multiple dividend-paying stocks into a single ETF can help investors diversify their exposure to dividend payers at a relatively low cost.

However, not all dividend-focused ETFs are created equal. Here's what to look for based on your goals and appetite for risk.

Generally, dividend-focused ETFs take one of two approaches when selecting their holdings:

• Highest payers focus exclusively on those companies that have the highest dividend yields among their peer group.
• Consistent payers focus on companies that have a history of paying, or even increasing, their dividends.

ETFs composed of the highest payers may seem like the better way to go, but high yields are sometimes the result of a falling stock price. For example, a stock trading at $50 per share with a dividend of $0.75 per share has a dividend yield of 1.5% ($0.75 ÷ $50 = 0.015). If the stock falls to $35 per share and still pays the same dividend, its yield jumps to 2.1% ($0.75 ÷ $35 = 0.021).² A declining share price isn't always cause for concern, but if it's the result of underlying weakness in the business, the company may eventually need to cut or eliminate its dividend.

Conversely, companies that have a long-term track record of consistently paying and/or raising their dividends may be more financially sound, which may mean more stability for investors—albeit with lower yields.

Even two ETFs that focus on the same type of dividend payers won't always have similar portfolios. Some ETF managers weight their holdings by market capitalization, some weight every holding equally, and some weight based on yields, with the highest-yielding stocks receiving the greatest representation.

However, when funds are weighted by yield, they can be forced to buy distressed stocks whose yields are high simply due to falling stock prices. This was the case in 2019, when dividend ETFs weighted by yield increased their holdings of Tanger Factory Outlet Centers Inc.³ When the stock failed to meet certain requirements, including minimum market value, these funds were forced to sell and may have been negatively impacted by short sellers who were well aware of the index methodologies.

That said, some dividend ETFs track indexes that attempt to exclude high-yielding companies that may be most vulnerable to dividend cuts, and many, including those that weight by yield, limit their exposure to individual sectors and stocks to a certain percentage of the fund's holdings.

Investing in a dividend ETF can also be something of a sector play, as funds can have very different sector allocations within their portfolios due to the specific rules used to construct the indexes they track. 

For example, the S&P 500^® Dividend Aristocrats^® Index includes companies within the S&P 500^® Index that have increased their dividends every year for the past 25 consecutive years. Compared with other indexes, it contains more exposure to stocks in the Industrials and Consumer Defensive sectors.

In contrast, the S&P 500 High Dividend Index, which equally weights the 80 highest-yielding stocks in the S&P 500 regardless of how long they have paid and increased their dividends, ends up with more exposure to Financials, while the Dow Jones U.S. Select Dividend Index, which doesn't limit its selections to large-cap companies, has more exposure to Utilities.

Furthermore, some index methodologies may limit the number of stocks in a given sector or exclude a sector entirely. For example, many dividend-focused indexes exclude real estate investment trusts (REITs), which reduces their allocations to the Real Estate sector.

There's nothing wrong with investing in particular sectors, per se, but too much exposure to a single sector can make your portfolio vulnerable if that sector hits a rough patch. Additionally, consider whether excluding certain sectors will impact your portfolio's overall diversification.

When researching dividend ETFs, be sure to check their prospectuses—and investigate the methodologies for the indexes they track—for important details that differentiate them. Ask yourself:

• Does the payer mix make sense for my goals? The fund should align with your overall objective, whether that's growth, income, or both. If you're a retiree looking for steady income, you may want a fund that prioritizes consistent payers. If you're willing to take more risk for higher yield, a fund that focuses on the highest payers might be a better fit.
• How will the weighting methodology affect my portfolio concentration? Examine how each fund weights and rebalances its holdings to avoid overexposure to a single sector or stock. Even if the fund strikes the right balance today, be aware that its holdings can shift over time—although many funds limit their exposure to individual sectors or stocks at a certain percentage of the total portfolio.
• How might the fund's exposure to certain sectors affect its performance? Some funds may be limited to investing in certain sectors, while others may exclude some sectors entirely. Check to see how a fund's holdings are distributed by sector to ensure you aren't exposing yourself to overconcentration risk and that its investments align with your view on a sector's near- and long-term prospects.
• What other factors influence the fund's portfolio mix? Investigate whether the ETF uses additional filters to select its holdings, such as requiring a consistent history of paying dividends, excluding the very highest-yielding stocks, or requiring companies to have strong fundamentals (e.g., cash flow).

As with any investment, ETFs and their underlying stocks can experience price declines. Plus, it's important to remember that a company can cut its dividend at any time. However, by holding a fund with many different dividend payers in its basket, your yield is less likely to suffer if a single company cuts its dividend. Just be sure you fully understand the type of exposure your ETF is providing.