Dividend ETFs Are Taking Off, But Advisors Recommend Caution

As interest rates fluctuate, the search for consistent yield can frustrate many advisors and their clients. Lately, a growing number of investors say they have found a solution in dividend-generating exchange-traded funds, which can yield as much as 12%—and in some cases even more. But experts caution that these outsize yields often come at a high price.

“A downside of high-dividend products is that not all dividend yields are created equal,” said Joe Alger at Crestwood Advisors in Boston. “A company with deteriorating fundamentals and a declining share price can have a deceivingly attractive dividend yield, representing a potential value trap of an investment.”

To mitigate this risk, he prefers dividend strategies that focus on high dividend growth as well as yield. “Companies with high dividend yields but deteriorating fundamentals are less likely to be growing their dividend at high rates, simply for the reason that they likely can’t afford to,” he explained.

NAV Erosion

According to Morningstar Direct, there were 16 dividend ETFs in the U.S. that yielded 6% or more in the 12 months ended November 1. Altogether, they held some $10.3 billion in aggregate assets. To generate their yields, though, insiders say that many of them invest in volatile, risky securities—often companies that must pay high dividends to attract and keep investors, even if the dividends eat into the net asset value (NAV).

“The trade-off comes with a potential for NAV erosion, which is often a byproduct of high distributions—sometimes requiring the fund to distribute a return of capital,” said Rene Reyna, head of thematic and specialty ETF strategy at Invesco in Downers Grove, Ill.

For instance, Invesco’s KBW High Dividend Yield Financial ETF yields about 12.4%. That’s the kind of number that can make an investor swoon. The lion’s share of its assets are in real estate investment trusts (REITs) that borrow to invest in mortgages and mortgage-backed securities, which are bond-like shares of bundled real estate debt.

These so-called mortgage REITs can be riskier than some investors would think and can be subject to sharp downturns. During the pandemic, some lost more than 50% of their value.

Nonetheless, in the 12-month period ending November 1, however, the KBW ETF’s total return was roughly 27%, including price appreciation and dividend reinvestment. That lagged the S&P 500 by roughly 11 percentage points over the same time.

“High-dividend funds like these are potentially a great fit for any income-focused investor who values regular cash flow over capital growth,” said Reyna. “It’s all about balancing income with risk tolerance and long-term goals.”

Not surprisingly, one primary market for these ETFs is retirees, he said. But the funds can also appeal to younger investors who want to reinvest dividends for compounding. The funds might also find fans among private nonprofit institutions and foundations, which are required by the IRS to make charitable distributions of at least 5% of their assets every year.

Reyna cited fluctuating interest rates, the need for inflation protection, and the aging population among the drivers of growing demand for dividend-payers. “Investor demand for high dividend-paying funds is on the rise, driven by the perennial need for income,” he said.

Yet industry watchers recommend that advisors carefully weigh all the available choices for generating above-average yields. “High-yielding equity ETFs come in different flavors,” said Michelle Connell, president and CIO of Portia Capital Management in the Dallas-Fort Worth area. That means investors should “determine how the high yield is being generated.”

Options Help Out 

Besides those funds included in the Morningstar data, which primarily hold dividend-paying equities, others hold debt instruments, and still others use “option overlay strategies,” Connell said, referring mainly to covered-call or option-income funds. These augment yields by selling (or “writing”) call options on underlying assets for an up-front, nonrefundable premium. The third parties that purchase the options can then buy the asset at a predetermined “strike price” if it appreciates beyond that price before the option expires. If the asset doesn’t surpass the strike price, the option simply expires. Either way, the fund keeps the fee paid for the option.

A good example of a fund using options, Connell says, is the JPMorgan Nasdaq Equity Premium Income ETF, which holds roughly $18.4 billion in assets and posted a 12-month yield of some 9.5% as of November 1. (Over that time, the ETF’s total return was nearly 26%, which included its price appreciation and dividend reinvestment.)

When ETFs that employ this strategy were introduced in the early 2000s, it was seen by some as “a great equalizer that allows investors of all sizes to access investment strategies that were previously only used by the largest institutional investor or ultra-high-net-worth individuals,” said Howard Chan, CEO of Kurv Investment Management in San Francisco. “However, not all high-yield covered-call ETFs are the same.”

He and others suggest taking a close look at not just quantitative but qualitative factors before choosing a fund.

For instance, Vanguard’s High Dividend Yield ETF is a passively managed fund with about $73 billion in assets. Since it tracks the FTSE High Dividend Yield Index, it’s made up of a broad, diverse portfolio of conservative, large equities, which reduces its investment risk, according to market experts. Since its inception in 2019, at about $29, the shares have soared roughly 450% to a recent $131. The price for that stability, though, is a relatively low 12-month yield of 2.8%. (Its 12-month total return through November 1 was about 28%, including dividends.)

“It’s important to understand how it fits into the mix with other equity investments,” said Dan Newhall, head of portfolio solutions in Vanguard’s financial advisor services group in Malvern, Pa. The ETF “tends to exhibit value characteristics,” he said, so it’s often paired with growth stocks in a balanced portfolio.

“There can be an enormous difference in quality, fees and management skill among mutual fund and ETF managers,” said Kent Demien, director of research at Johnson Financial Group in Milwaukee. He said companies that pay high dividends also “are often at risk of having their dividends cut. It can be difficult for companies to continue to generate high dividends every year in perpetuity.” When companies cut dividends, he added, their stock price is often “punished” by investors. “Therefore,” he said, “high-dividend ETFs and mutual funds may not be suitable for investors who do not fully appreciate this risk.”

Keep Taxes In Mind

Investors in these funds must also consider taxes. Dividend ETFs typically produce a monthly payout that’s partly taxable as ordinary income and partly considered “return of capital,” which is not taxable. If the retiree generates income by periodically selling off chunks of stock, the income is usually taxed at the lower long-term capital gains rate instead.

Nevertheless, analysts anticipate that the market for high-yield products will continue growing. It “has a couple of positive tailwinds behind it,” said Alger at Crestwood Advisors. “The first is the rapid innovation and diversification of product offerings. [The second] is the record number of Americans on pace to reach age 65 in the coming years and enter retirement age, which is likely to drum up additional appetite for income-heavy products.”

As seen in FA-Mag.com