Dividend ETFs for Income and Diversification
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Interest rates are at record lows as investors seek refuge from the global economic turmoil in US Treasury bonds and other low-risk assets: 10-year US bonds are yielding around 1.7%, which hardly constitutes a convenient entry price from a long-term point of view.
If the European crisis keeps getting worse, or if we see another round of quantitative easing from the Federal Reserve, interest rates could get even lower and fixed income investors would be in a very tough situation when looking for attractive opportunities for income.
Considering this situation, it would be wise for long-term investors to gradually consider changing their asset allocation away from fixed income markets into more convenient income alternatives like dividend stock ETFs. This would clearly imply assuming more volatility in the short term, but over the next years dividend stocks have big chances of outperforming fixed income markets.
After all, bonds don't have much upside potential at current levels, at least not from a long-term perspective. Sooner or later the world economy will become more stable, and interest rates will have to go up in order to come closer to historical levels and keep up with long-term inflation averages.
Over the next weeks or months bonds can continue outperforming dividend stocks as long as fear remains a powerful force in financial markets, but looking at the next few years, the risk and return equation becomes much more favorable for dividend ETFs.
Those investors with a long-term investment horizon and high tolerance to volatility should consider the possibility of gradually reducing their exposure to bonds into dividend stocks in order to adapt efficiently to the current environment and achieve better long term returns.
After all, the diversified exposure that ETFs provide makes the volatility issue a much smaller problem than with individual stocks. The companies that make the portfolio of an ETF will not go broke, at least not a big percentage of them, regardless of how negative economic conditions become. And they certainly provide better income levels than most bonds right now, with the additional advantage of more potential for price gains.
And you don´t need to move directly into stocks to add instruments with high dividends to your portfolio: Vanguard REIT ETF (NYSEMKT: VNQ), provides exposure to more than 110 Real Estate Investment Trusts.
REITs usually add diversification to a portfolio comprised of equities and bonds, and yielding a 3.3% in dividends, this ETF looks better than most bonds from an income point of view. Also, real estate has plenty of upside room over the next years, so the potential for capital gains should not be disregarded for this kind of assets over the following years.
For dividend paying stocks iShares Dow Jones Select Dividend (NYSEMKT: DVY) is a solid alternative. It has a portfolio that includes 100 strong dividend players from different sectors, although utilities represent more than 30% of the holdings. It pays a 3.4% dividend yield; its holdings are primarily big defensive stocks.
Speaking about defensive stocks with juicy dividend yields, Utilities SPDR (NYSEMKT: XLU) is a very popular ETF to invest in the utilities sector, and it has a 3.9% dividend yield. These big companies will not go broke in a recession, and they may even benefit from a low interest rate scenario. Utilities usually operate with high levels of debt due to the stability of their business, so lower financial expenses are a plus for this sector.
Another defensive sector that usually provides nice dividend yields is consumer staples, and Consumer Staples Select Sect. SPDR (NYSEMKT: XLP) is an alternative to gain exposure to those companies. Corporations like Coca-Cola, Procter & Gamble and Wal-Mart have sustained their dividends through the deepest recessions, and they are well positioned to continue delivering growing dividends in the middle term. This ETF yields 2.6% in dividends, and it has a portfolio that includes many high quality companies.
Those willing to venture into emerging markets in search of better opportunities in an uncertain environment may want to consider WisdomTree Emerging Markets High Yielding Equity Fund (NYSEMKT: DEM). This ETF focuses on the highest dividend-yielding companies in emerging markets, with financials and telecom occupying 26.8% and 20% of assets, respectively.
DEM yields 4% in dividends, looking quite attractive when it comes to income. Emerging markets are not considered a defensive asset class, so this instrument can be quite volatile in complicated markets, but over the long term it offers a lot of upside potential. Emerging countries have stronger economies and better growth prospects than Europe or the US, and for this reason they have good chances of over performing developed markets.
Dividend ETFs are not a perfect substitute for bonds, and they can certainly be more volatile. But when considering long term perspectives, they are very well positioned to provide a better risks and return trade off.
acardenal has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.