How Can I Pick The Best Dividend ETF?
Summary Dividend ETFs are tools for building a better retirement. Finding the right exchange traded fund for an individual investor requires knowing how the investor wants to use the tool. Investors that want to dollar-cost average into the ETF will need to consider the impact of trading costs. When an investor is looking at the dividend yield, they need to calculate the yield across the entire portfolio. Investors should aim to have a healthy margin of safety to facilitate a buy-and-hold strategy. Many investors have recognized that they need to create a dividend portfolio with strong yields and low risks to protect their lifestyle in retirement. ETFs with strong dividend yields are the quickest way that investors can get access to a diversified group of high dividend companies that will provide a growing stream of income for them to live on without having to use up the principle. Drawing down the portfolio eventually leads to a death clock as investors are forced to wonder if they will outlive their money. Building a portfolio around a high-quality ETF is one way to prepare for a long and happy retirement. It Starts With You When you want to find the right dividend ETF, you need to recognize that you are looking for a financial tool. Remembering that the ETF is simply one tool will make it easier to find the best one for you. There are certain factors that will always be important, but the importance of each factor depends on the investor. Buying Strategy Are you making one lump purchase, or are you planning to dollar-cost average into the position over time? The answer is very important, because it determines which aspects of the investment will be most important in analyzing your long-term costs of owning the tool. If you intend to buy all of your shares this month with a large pile of cash, then trading commissions (generally under $10) will be largely irrelevant. On the other hand, if you are planning for a retirement in 20 years and intend to dollar-cost average into the ETF by buying once every week, every two weeks, or each month, trading commissions will be an important consideration. If you fall into the category of frequently making small purchases, then you will want to either prioritize ETFs you can trade for free from your current brokerage, or consider changing brokerages if necessary. Personally, I fall into this category. On average I make about three acquisitions a month through various accounts. I hardly ever sell a high-quality ETF, but I like to be able to make small purchases on a consistent basis. Expense Ratios The expense ratio is a very important factor for the long-term investor. If you follow the simple “buy and hold” strategy, which I endorse, the expense ratio can become a big deal when your holding period stretches from a few years to decades. If you are holding these funds in a taxable account, selling one ETF to buy a different one could incur capital gains taxes. Therefore, I prefer larger funds with a solid history of operating at low costs. In general, expense ratios less than 0.25% are reasonable, and ratios less than 0.13% are excellent. Net or Gross The net expense ratio is what investors actually give up from the fund each year. Some advisors will say that the net expense ratio is the only one that matters, but the gross expense ratio gives investors an idea of where expense ratios might go in the future. If you’re buying an ETF with a low net expense ratio and a high gross expense ratio, it would be better to have the fund in a tax advantaged account so you can change ETFs if the ratio changes significantly. Liquidity and Spreads If you’re going to buy shares in exchange traded fund, you should look into the liquidity and the spread. In general higher levels of liquidity and lower spreads will occur together. A large spread is like an increase in the trading commissions because it will increase your effective costs for each share you buy or sell. So long as the spread is regularly very small, weaker liquidity might not seem like a problem. If the investor is certain they will not need access to the principle at any point, then the weaker liquidity shouldn’t be too much of an issue. On the other hand, if you are not fully insured and might suddenly need access to a large amount of cash, it would be unwise to choose an ETF with poor liquidity. Dividend Yields and the Margin of Safety When you’re buying a dividend ETF, one of the first things you need to ask is whether the dividend yield is going to be sufficient for your needs. When an investor buys into the fund, they should be looking at the dividend yield on their entire portfolio. If the investor is wisely including treasury securities as part of their portfolio, they may have a weaker portfolio yield. Since the ETF will be a major source of income, investors may want to use it as a core piece of their portfolio and allocate between 25% and 60% of their wealth to the ETF. Therefore, they should look at the dividend yield on the ETF. However, simply looking at the number listed for “dividend yield” is insufficient. Investors should pull up the “dividend history”. When investors look at the dividend history, they should consider whether the fund pays monthly or quarterly. If the fund pays quarterly, do you feel comfortable managing your living expenses on a 3 month period rather than monthly? The next factor is looking at the dividends to determine if they have been cut on an annual basis at some point. If the fund has a long track record, investors can see how the fund performed during 2007. Remember that the goal of buying a high quality income ETF is being able to have a steady source of income without listening to the news. If dividends are cut during a recession, investors may be forced to “create dividends” by selling off shares. Under Modern Portfolio Theory selling shares is a perfectly acceptable way to generate extra dividends. Under Behavioral Portfolio Theory, the reality is that human psychology encourages the investor to sell off too many shares at the bottom of the correction. Margin of Safety When an investor is determining the yield they need from their investment to create a strong enough portfolio yield to cover their living expenses, they should ensure that there is a healthy margin of safety. Whether the dividend cut comes from the ETF or from other holdings in the portfolio, the investor needs enough income to know they can cover their expenses without being kept awake at night worrying about their portfolio. The more volatile the dividend history of the ETF, the larger the margin of safety should be. Investors using BDCs (Business Development Companies) or mREITs to strengthen their portfolio yield will need a larger margin of safety because those sectors have dramatically more dividend risk than a high quality dividend ETF.