The Fiscal Cliff and Dividend ETFs

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

With the fiscal cliff looming large, I have been rethinking my dividend ETF policy for a while now. It has seemed to me that an increase in the dividend tax rate does not necessarily mean that investors should and sell their dividend ETFs at artificially low prices. Dividend ETFs are just as much vulnerable as the broader market is. I would actually consider debutant ETFs like Global X Funds (NYSEMKT: SDIV), Market Vectors Preferred Securities Ex-Financials ETF (NYSEMKT: PFXF) and PowerShares S&P 500 High Dividend Portfolio (NYSEMKT: SPHD) as good options, given that market sentiment may actually undervalue them right now.

Indeed, prices of some of the popular dividend ETFs have been sliding southwards in the last month, as you can see below:

However, the decline may be a result of short term market psychology rather than anything more fundamental. Let me explain why.

Dividends Actually Increase When Tax Rates Increase

Historically, when dividend tax rates have increased, companies have tried to sidestep and increase dividends, albeit slowly, or gone in for repurchase. Cash-rich companies still have to distribute their income despite a higher dividend tax rate, so announcements of special dividends or higher dividends are not uncommon.

Dividends are Fundamentally Better than Capital Gains For Regular Income

Dividends provide what capital gains do not – regular income. Capital gains, on the other hand, are a dicey affair. They are highly dependent on market behavior, most of which is often erratic and unpredictable. Dividends provide a regular income even when markets are down. Dividends are purely a fundamental play while price movement in stock market is usually driven by news, trends, and momentum, and the worst of all, investor sentiment.

Other Reasons for Not Dumping Dividend ETFs

Most high dividend payers are concentrated in sectors that are not cyclical in nature and perform better in a downturn. These include healthcare, utilities, and consumer staples; industries that are least likely to see a drop in revenues even in a recessionary economy.

The increase in the dividend tax rate is not a given and the likelihood of a compromise cannot be ruled out. However, even if the tax rate on dividends is hiked, it is not likely to have a big impact as most dividend stocks are held in tax deferred retirement accounts.

Moreover, before getting out of the dividend ETF space, you need to consider other options. Barring municipal bonds, interest income from interest on fixed income securities is abysmally low and also taxed as ordinary income. Selling off dividend ETFs will definitely lower the tax you pay to Uncle Sam, but at the cost of lower returns.

Newer Dividend ETFs You Can Look At

Along with seasoned players in the space, such as Vanguard Dividend Appreciation ETF (VIG), iShares Dow Jones Select Dividend Index Fund (DVY) and PowerShares International Dividend Achievers ETF (PID), there are also some newer dividend ETFs that debuted in the last year and a half. Global X Funds debuted in June 2011, Market Vectors Preferred Securities Ex Financials ETF debuted in July, and the PowerShares S&P 500 High Dividend Portfolio debuted only a month back.

Although considered to be relatively riskier, due to lack of a track record and fewer assets under management, the newer dividend ETFs have given a new direction to stock selection by searching for newer stocks that provide attractive dividends.

Global X Funds

SDIV is basically an international fund that allocates 29% of its assets to the United States. Launched in June 2011, it may not appear to be a likely candidate for investment at first as new funds are often viewed as risky investments by the old guard. That is probably one of the reasons why many investors tend to ignore it and prefer older players such as SPDR S&P International Dividend ETF (DWX) and the PowerShares International Dividend Achievers ETF (PID) that have been around for some years now. SDIV, however, is a part of the newer concept of high dividend ETFs.

The fund pays a monthly dividend, has a 30-day 7.72 % SEC yield, and has provided better YTD appreciation compared to DWX and PID.


 

Market Vectors Preferred Securities Ex Financials ETF

PFXF was launched in July this year. Within a short span of four months, the fund has distributed $0.28 per share in dividends and appreciated 1%. The fund has given an entirely new direction to preferred stock ETFs. Instead of investing in bank stocks, the preferred sector of ETFs in this space, it creates its portfolio around REITs, electric utilities, auto, telecom, insurance, and energy. PFXF has been designed to track the Wells Fargo Preferred Securities Ex Financials Index. However, it must be noted that Wells Fargo defines financials differently from the popular GICS scheme. In GICS, financials in PFXF account for 37%. It has an expense ratio of 0.40, which is lower than other preferred stock funds.

PowerShares S&P 500 High Dividend Portfolio

SPHD became a victim of a wrong choice if timing as it debuted only a month back when markets began to react to the fiscal cliff. Utilities and telecom, the sectors that took a big hit form almost 31% of this fund’s portfolio. However, SPHD was able to collect $23 million, which is pretty good for a month’s work. The USP of the fund is low volatility and high dividend. The fund paid a $0.10-dividend in October, 2012. The 30-day SEC yield is 4.74%.

Conclusion

Dividend tax rates and the stock market are not correlated; the stock market discounts available information and prices fully reflect all information that is publicly available. One needs to look at the impact of the change, not after it comes into effect, but before that also – the realization that prices will come down comes when the change is still making its way through the legislative process.

Markets tend to correct themselves and a correction was due; the dividend tax rate increase is just being made a scapegoat.


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