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All About the Dividends

By Benjamin Shepherd on January 18, 2012

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For just the second time since 1947, the dividend yield on the S&P 500 exceeds the yield on 10-year US Treasury notes. The S&P 500 currently yields 2.2 percent, while 10-year Treasuries yield just 1.85 percent.

The last time this scenario occurred was during the 2008-09 financial crisis, so that suggests investors are extremely skeptical about equities’ future growth prospects. Indeed, the price-to-earnings multiple of the S&P 500 continues to compress, as investors consider the possibility that the developed world could fall into a recession later this year.

Source: Bloomberg

That outlook continues to drive extraordinary demand for US Treasury bonds. That huge demand was reflected in the most recent sale of 10-year issues, which fetched historically low prices and yielded just 1.91 percent.

Although it’s difficult to find value among bonds in such an environment, equity-income funds still offer decent values. And if stock prices remain depressed during 2012, dividends will likely be the major source of investors’ returns, just as they were in 2011.

Among equity-income exchange-traded funds (ETF), I favor iShares Dow Jones Select Dividend Index (NYSE: DVY). The ETF currently yields 3.4 percent and its average daily trading volume offers ample liquidity.

The ETF tracks the Dow Jones US Select Dividend Index, a basket of the 100 highest-yielding stocks in the Dow Jones US Index. But stocks aren’t selected for the index solely on the basis of yield, they also must pass a number of qualitative screens.

The first screen removes names that have dividend-per-share ratios below their five-year average. The next step eliminates stocks with payout ratios of greater than 60 percent. From there, the screening process removes any stocks whose history of paying dividends is less than five years, as well as any stocks whose average daily trading volume is below 200,000 shares.

Once the screening process is complete, the index is created using a yield-weighted methodology, with no position exceeding 10 percent of assets.

The selection process is then repeated each December.

The fund’s focus on yield means that its holdings skew toward value names. Additionally, the ETF’s portfolio has a substantial tilt toward smaller-cap stocks: mid-cap stocks comprise more than a third of assets, and small caps comprise 14.9 percent of assets.

From a sector perspective, the fund’s three largest allocations are to utilities (31.1 percent of assets), consumer staples (15.9 percent) and industrials (14.9 percent). These are cyclical sectors, so the ETF can suffer heavy losses during economic downturns.

Despite the greater risk resulting from its smaller-cap, cyclical holdings, the ETF’s yield and its low 0.40 percent expense ratio make it an excellent option for long-term investors.

SPDR S&P International Dividend (NYSE: DWX) is also worth noting because of its attractive 6.2 percent yield. The ETF tracks an index comprised of the 100 highest-yielding common stocks and American depository receipts listed on the primary exchanges of the S&P/Citigroup Broad Market Index. Like iShares Dow Jones Select Dividend Index, the ETF screens stocks for quality and liquidity in addition to payouts.

From a sector perspective, the fund’s allocations to communications companies (25.9 percent of assets), utilities (17.8 percent) and industrials (11.4 percent) provide defensive positioning. However, the fund’s 54.9 percent allocation to European stocks could prove problematic if the region’s debt crisis deepens. Fortunately, the ETF focuses on essential services instead of more speculative fare, so it should produce a positive return this year.

SPDR S&P International Dividend has a reasonable 0.45 percent expense ratio, so it’s a great way to add some additional income to your portfolio.

What’s New

The pace of ETF launches slowed during the holidays, but a bevy of new ETFs hit the market last week.

Volatility was a key theme in last week’s launches, with Invesco PowerShares Capital Management launching PowerShares S&P Emerging Markets Low Volatility Portfolio (NYSE: EELV) and PowerShares S&P International Developed Low Volatility Portfolio (NYSE: IDLV).

The emerging markets fund tracks the 200 least volatile stocks in the S&P Emerging BMI plus Large Mid Cap Index, while the developed market fund tracks the 200 least volatile names in the S&P Developed ex US and South Korea Large Mid Cap BMI Index.

Each fund charges a 0.25 percent expense ratio.

In a similar vein, Direxion launched Direxion S&P Latin America 40 Volatility Response Shares (NYSE: VLAT), Direxion S&P 500 Volatility Response Shares (NYSE: VSPY) and Direxion Risk Control S&P 1500 Volatility Response Shares (NYSE: VSPR).

All three funds use a strategy that involves shifting their exposures to equities and Treasury bonds based on market volatility. They use S&P Risk Control indexes that are based on an exponential volatility curve that dictates when the funds are allocated to equities and when they are allocated to Treasury bonds.

The S&P 500 fund will shift between the S&P 500 and Treasuries, the S&P 1500 fund will shift between the S&P 1500 Index–which includes large-cap, mid-cap and small-cap names–and Treasuries, and the Latin American fund will shift between the S&P Latin American 40 Index and Treasuries.

Each ETF charges a 0.45 percent annual expense ratio, which is relatively inexpensive given their intelligent indexing strategies.

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