ETF Talk: Treading Treacherous Waters for Dividends

Dividends are a great way to earn some extra income. You also can grow your principal through capital appreciation with good dividend-paying equities. One way to gain both of these benefits is through dividend-focused exchange-traded funds (ETFs). But the path to doing so has become increasingly treacherous for investors to follow as once-solid corporations struggle for survival. If you are an income-oriented investor, here are four simple tips on how to select these types of funds.

First, pick ETFs that hold stocks in stable companies with sustainable dividend yields. In this market, even traditional dividend-paying companies such as Bank of America, General Motors and Citigroup, have suspended their dividends because of poor performance. In 2008, 62 companies in the S&P 500 cut their dividends. To protect your capital and to enjoy steady income, choose ETFs that invest in companies likely to continue paying dividends.

Second, find ETFs that are invested in cash-rich companies. As I have said many times before, in bear markets, cash is king. Cutting dividends harms the company’s reputation and typically hurts its stock price, as well as your principal. Find ETFs that hold stock in firms with fat cash positions and your dividends likely will keep coming.

Third, beware of ETFs that have too much exposure to any single sector. Take a close look at the financial or energy sectors, since any ETF that follows these sectors could be down more than 50% in the last year — costing you much of your initial investment. Remember, when earnings fall sharply, dividend cuts often follow.

Finally, and possibly most important, do your homework before you buy any ETF. Know its holdings, find out if the fund is leveraged or not, check its past performance and make sure that it is well-diversified.

ETFs are a great and easy way to moderate risk in any portfolio, especially in times of volatility. Several studies have found that dividend-paying stocks held for the long run provide better risk-adjusted returns than low-paying ones. Also consider your appetite for risk and your short- and long-term financial goals. Then, invest accordingly.

While I currently am not recommending any of the dividend-paying ETFs in the table below, the tips that I have shared should help you in assessing them.

If you want further guidance about which dividend-paying ETFs to trade, check out my ETF Trader service by clicking here. As always, I am happy to answer any questions that you have about ETFs. To send me your questions, simply click here. I will try to follow up in a future ETF Talk.