By Lori Ioannou
April 19, 2023
Retirees looking for ways to boost their income face some serious challenges—inflation, market volatility and a looming possibility of recession.
Investors have poured $2.8 billion into ETFs that buy dividend-paying stocks this year through April 14./Illustration: Alex Nabaum
Many are hoping that ETFs that focus on dividend-paying stocks can help. The attraction of these equities is that they offer income, plus the potential for stock price appreciation.
“It’s a tried-and-true strategy,” says Lewis Altfest, founder and chief investment officer of Altfest Personal Wealth Management in New York. “For retirees, there is comfort in knowing a percentage of their total return will come from cash in the form of dividends no matter how stock prices fluctuate.”
Investors have poured $2.8 billion into ETFs that buy dividend-paying stocks year-to-date through April 14. There are now 180 U.S. dividend ETFs, with assets totaling more than $384 billion, according to CFRA Research. ETFs in general, because they invest in baskets of equities, offer investors more diversification than owning individual stocks and more tax efficiency. And pursuing the dividend theme is seen as a good inflation hedge considering that S&P 500 dividend growth has outpaced inflation from 2000 through March 2023, according to data from S&P Dow Jones Indices and the U.S. Bureau of Labor Statistics.
Financially resilient
What’s more, financial advisers say, these funds invest in stocks that typically perform well during market downturns, are financially resilient and tend to have a high return on assets. Last year, for instance, despite stock-market turbulence, companies in the S&P 500 set a dividend payout record. The total aggregate dividend payout in 2022 reached $564.6 billion, up from $511.2 billion in 2021, according to Anu Ganti, senior director of index investment strategy, S&P Dow Jones Indices.
“This year the outlook for S&P 500 dividends continues to be positive with dividend increases expected to average around 5%,” says Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.
A look at the historical performance of dividend stocks reveals how they reward investors. Nearly 40% of the annualized total return of the S&P 500 came from dividends from January 1926 through March 2023, according to S&P Dow Jones Indices. The annualized return consists of both capital appreciation and dividends reinvested.
For this reason, it’s not surprising that dividends as a percentage of personal income rose to 8.5% in the fourth quarter of 2022 from 3.2% in the first quarter of 1980, according to data compiled by S&P Dow Jones Indices and the Bureau of Economic Analysis.
Dividend ETFs come in several varieties. According to Ben Johnson, head of client solutions, asset management, at Morningstar, those that focus on companies offering the highest current yield are “dividend yielders”; ETFs that choose stocks with a history of raising dividends are known as “dividend growers”; and “hybrid dividend ETFs” try to strike a balance by looking at current dividend yield and the prospect of future dividend growth.
Though most are passively managed index funds, a growing number are actively managed.
The aristocrats
Some financial advisers steer their clients to ETFs that invest in so-called dividend aristocrats, or companies in the S&P 500 index that have a history of increasing dividends for 25 consecutive years or more.
Among the ETFs that invest in such stocks is ProShares S&P 500 Dividend Aristocrats ETF (NOBL), an $11.2 billion fund of 66 stocks that tracks the S&P 500 Dividend Aristocrat Index. Its 12-month yield is 1.91%, its year-to-date return through March 31 is 1.8%, and its one-year return through March 31 is minus 1.9%. While its current yield is only 2.11%, it has had over a 10% annual compounded dividend growth rate since its inception in 2013.
“Historically, S&P 500 aristocrats have traded at a premium, but they are selling at a discount now,” says Simeon Hyman, global investment strategist at ProShares, a provider of ETFs. As of April 13, the median price-to-earnings ratio for aristocrats was 17.3 compared with 18.5 for the S&P 500.
Which dividend ETF investors choose will depend on their portfolio strategy and financial goals. For instance, while some funds are constrained to large-cap U.S. companies, many focus on small-cap and midcap companies. Others hold international stocks that pay dividends.
“It’s important to do your homework and know what you’re buying,” says Jeffery Markarian, managing director of Harbor Capital Advisors. “Check the holdings and the fund’s industry sector diversification. Many of these index funds are concentrated on a few select names. Also check the companies’ dividend histories.”
Don’t be ‘lured’
Mr. Altfest, the wealth manager, warns investors not to be “lured” to dividend ETFs that simply offer the highest dividend yield, which is the amount of money a company pays shareholders divided by its current stock price. When yields are very high, often it’s an indication stock prices are falling. That drop might be happening for a good reason, or it may be that the company is distributing too much of its earnings and not enough cash to support daily operations or expansion.
“Concentrating just on the fund’s dividend yield is the most common mistake investors make,” says Matthew Bacon, a certified financial planner at Carmichael Hill & Associates in Gaithersburg, Md. “It’s dangerous since you could end up with something you were not hoping for.” Instead, Mr. Bacon says, “look at the underlying allocation of the fund to get a sense of how that dividend is generated. Some ETFs are made up of riskier components than others, which could result in a negative total return after unfavorable price changes.”
Investors also should beware of overconcentration in certain sectors by dividend funds.
“In the hunt for yield, more money is flowing into high-yield dividend ETFs this year rather than dividend aristocrats,” says Aniket Ullal, CFRA Research’s head of ETF data and analytics. “These funds tend to have more sector concentrations in such areas as real estate and utilities, and they are more at risk of having unexpected dividend cuts since they often have weaker fundamentals in terms of cash flow and leverage.”
Mr. Altfest advises his clients to stay in their lanes, with regard to risk tolerance, in determining how much of their portfolios to allocate to dividend ETFs. He says some of his clients who are fearful of a recession in the second half of this year are allocating up to 20% right now.
Dow Jones & Company, Inc.
