Are Domestic Income ETFs Still Attractive?

Ankush is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Although the domestic U.S.benchmark interest rates have risen quite a bit in the recent past (with the 10 year Treasury rates near the 2.50% mark) the search for yield is by no means over.

Apart from the paltry yield on fixed income securities, investors have had to seek solace in riskier investment avenues like high yield bonds, Master Limited Partnerships, Real Estate Investment Trusts and dividend paying equities in order to quench their thirst for yield.

But with equity prices in their all time high levels, the dividend yields (expressed as the percentage of dividend paid to their current market price) for these higher yielding equities have started to look ordinary.

Although by no means am I implying that these higher yielding equities have become un-attractive. There is still some scope for alpha in the domestic income yielding equity space, especially when compared to other high yielding asset classes.

Having said this, it is prudent to note that considering the risk-return framework of these investment avenues is of prime importance. This is especially true, given the fact that current income seeking investment objective generally come with a substantially lower risk tolerance.

Of course there are definitely some quality stocks which provide current income opportunities. I believe exchange traded funds focusing on current income are the way to go for investors seeking a diversified taste coupled with the income flavor.

Forget Exchange rate fluctuations

Here I would like to focus on products from the ETF space which focuses on domestic U.S investment avenues rather than international. This spares investors the horrors of currency risk.

It is true that emerging market investment avenues do provide a substantially higher yield play than the domestic U.S.ones, but this advantage seems to have reversed viciously of late. This is primarily because of the sharp fall in most of the emerging market currencies versus the U.S. dollar which has brought down the effective rate of return for investors with emerging market exposure.

Choices available

Now that you are aware of the advantages and attractiveness of the domestic income ETFs, let’s have a closer look at the choices available to the investors.

Of all the income focused ETFs available, there are 3  which particularly impress me. These are the Vanguard Dividend Appreciation ETF (NYSEMKT: VIG), Vanguard High Dividend Yield ETF (NYSEMKT: VYM) and the iShares Dow Jones Select Dividend ETF (NYSEMKT: DVY). These ETFs not only enable investors to earn high yields in a cost effective manner, but also provide ample opportunity to earn the same effective rate of return as any growth oriented investor focused on capital appreciation.

The chart below highlights this point in greater detail:-

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The chart compares the year till date performance (cumulative daily returns) of the aforementioned three ETFs along with that of the SPDR S&P 500 ETF (NYSEMKT: SPY). We can see that the dividend focused ETFs (except VIG which has lagged behind majority of the times) have mostly been at par or even out-performed the gigantic SPY on most occasions.

Here lies the “power of compounding” as Warren Buffett would say. Although the dividend focused ETFs primarily have a low risk-return profile, the performance is at par with (or even better than) the growth oriented SPY. While this might not make much of a difference to growth oriented investors, for income seeking investors this is a very important consideration.

Firstly because it helps them to earn that extra ounce of current income which they are so desperately seek, that too without missing out on the capital appreciation opportunities. Secondly, it helps them to achieve this primary objective without distorting their fragile risk-return trade-off which I earlier talked about in the first half of the article.

Thus all in all, these income generating ETFs can go a long way in satisfying the needs of the income seeking investors.

A look at the individual attributes

Vanguard Dividend Appreciation ETF (NYSEMKT: VIG) tracks the performance of the NASDAQ US Dividend Achievers Select Index which selects stocks on the basis of their growing annual dividend yields. The portfolio is comprised of approximately 146 stocks.

The ETF charges just 10 basis points in fees and expenses and has an asset base of around $17.2 billion. VIG has added about 19.51% in 2013 paying around 2.1% as dividends.

Launched in the same year as VIG, the Vanguard High Dividend Yield ETF (NYSEMKT: VYM) tracks the performance of the FTSE High Dividend Yield Index. Like its Vanguard counterpart, this ETF also selects stocks n the basis of the growing dividend yields. It charges investors just 0.10% as expense ratio and has an asset base of $6.69 billion.

VYM has returned around 22.14% year till date paying out 2.85% as dividends.

Compared to the two Vanguard ETFs discussed above, the iShares Dow Jones Select Dividend ETF (NYSEMKT: DVY) is a more expensive choice as it charges an expense ratio of 0.40%. However, it also has a superior dividend yield of 3.23%.

Launched in November of 2003, it is the youngest of the three ETFs but has managed to amass an impressive asset base of $12.98 billion. DVY has returned 21.83% and has an average daily volume of roughly 748,000 shares.

Here it is worthwhile mentioning that investing style is entirely dependent on individuals’ financial goals. No investing style is superior that the other. In fact it is just a matter of analyzing market environment and taking investment decisions accordingly. It is this characteristic that separates the winners from the rest.

Having said this, it is also prudent to note that in this current environment of low yields it is very important for investors not to get tempted in search of yields and expose themselves to riskier investment avenues. Instead investors would be better off trying to generate current income the conventional way and these ETFs surely are effective ways to do that.

Ankush Shaw has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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