Dividend exchange traded funds made a big splash in 2011 and most held up much better than the S&P 500 as investors were drawn to safety and income. Yet looking ahead to next year, there are increasing concerns that this strategy could be a “crowded” trade and that dividend ETFs may trail the market if stocks should rally.

The $9.3 billion iShares Dow Jones Select Dividend (NYSEArca: DVY) is up 10.6% this year, compared with a roughly 1% gain for the S&P 500, according to Morningstar. The fund’s top sector exposure is in utilities, which has helped in 2011 due to the sector’s outperformance.

SPDR S&P Dividend ETF (NYSEArca: SDY) also became an investor favorite in 2011. It tracks the S&P High Yield Dividend Aristocrats index, made up of 50 of the highest yielding companies in the S&P Composite 1500 constituents that have managed to increase dividends every year for the past 25 years. The fund has over $8 billion in assets. The ETF yields 3.6%. [Four Dividend ETFs with Growth Potential]

“A large portion of the returns from investing in stocks comes from dividends,” Morningstar says in a profile of the fund. “Standard & Poor’s Index Committee utilizes several screens that result in a higher quality, more-diversified portfolio than the naive strategy of simply buying 50 stocks with the highest yield.” [Dividend ETFs are Not All the Same]

SDY has the flexibility to include companies from all market capitalizations, and the weighting by yield allows plenty of small-cap value companies the chance to become part of the index. [Dividend ETF Gets Warm Reception in Europe]

Over 2011, the top 100 stocks in the S&P 500 with the highest dividend yields are up 3.7% on average, before dividends, reports Jonathan Cheng for The Wall Street Journal. In comparison, the 100 lowest-yielding stocks are down 10% on average. [ETF Chart of the Day: Dividend Funds]

The companies that are steady in payouts, or increasing their dividends, are usually going to produce decent returns over time, reports Amanda B. Kish for Motley Fool.

Economic fundamentals for both developed and emerging markets are still uncertain at the moment. The Eurozone debt crisis is not going away, and in general global growth is not going to be taking off right away. The factors in the market are supportive of a low-yield environment for the near term.

However, critics believe that the recent run on dividends is making the asset category unsustainable, especially if the economy improves and investors take on riskier stock picks, which pay lower or no dividends.

“A crowded trade is always risky,” Vadim Zlotnikov, chief market strategist at AllianceBernstein, said. Zlotnikov noted that any signs of an economic upswing could end the dividend rally.

Other dividend ETFs:

  • WisdomeTree Large Cap Dividend (NYSEArca: DLN)
  • Vanguard High Yield Dividend (NYSEArca: VYM)

SPDR S&P Dividend ETF

For more information on dividend payers, visit our dividend ETFs category.

Tisha Guerrero contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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