Investors have a plethora of stock exchange traded fund options to choose from when it comes to income generation. However, dividend ETFs cover a variety of asset classes that can act differently in various market environments.
“All yield-generating vehicles, individual issues and exchange-traded products have risks or vulnerabilities that must be understood,” writes Noah Hamman, CEO of AdvisorShares, for ThinkAdvisor. “Adding dividend income from diverse sources is an outstanding risk management approach, especially with interest rates near all-time lows.”
Interest rates play varying roles when it comes to dividend-paying stocks. For instance, master limited partnerships and real estate investment trusts rely on debt financing. Consequently, if rates rise, the companies will have to borrow at a higher rate, which would eat away at potential profits. [Dividend ETFs Still Popular Despite Slowing Growth]
On the other hand, other dividend payers like utilities or telecom companies have been popular as a yield alternative during a falling rate environment. However, rising rates would make these companies less attractive as investors turn to new bond issuance with higher yields.
Potential dividend ETF investors should also be wary about chasing after high-yield investments. Going by a rule of thumb, investors should understand that the higher the yield, the greater the risk. For instance, mortgage REITs plunged last year following hints that the Federal Reserve would diminish its monthly bond purchasing program.
Furthermore, many high-yield, diversified dividend ETFs can have large exposures to REITs and utilities sectors, so investors should watch their sector exposure as well. [High-Yield International Stock Exposure with SuperDividend ETF]
Dividend growth ETFs, which typically own stocks that have raised dividends for a long period, may not actually have a good track record for growing dividends. Hamman points out that if a company does not raise its dividend or even cuts the dividends, the ETF could remove the stock and replace it with another that meets the underlying index’s criteria for inclusion. Consequently, the replacement stock could issue a lower yield, effectively diminishing the overall dividend paid by the ETF. [Cue up Quality With This Global Dividend ETF]
“Many dividend ETFs had heavy exposure to financial stocks and now have less, which has been a drag on the dividends these funds pay,” Hamman said.
Moreover, investors have to consider an ETF’s own dividend payout time frame. For instance, the ETF may adhere to its own schedule, dishing out dividends after an underlying stock pays out its dividends. Consequently, an ETF could pay out less dividends if the fund doubles in size between receiving underlying stock’s dividend and paying its own dividend to fund shareholders.
For more information on dividends, visit our dividend ETFs category.