Nowadays you can buy just about any kind of ETF you like – including ETFs that hold dividend paying stocks. What’s cool about this idea is that if you choose carefully, you can buy very low cost ETFs and enjoy those juicy dividends at the same time. Win-win.
So what’s the problem with going that way? I’m glad you asked. In my opinion, there are three concerns:
1. Interest Rate Risk
It’s no secret that interest rates have just about nowhere to go but up. Why should you care about this? Well…the market knows that when rates go up, investors who own high dividend stocks could dump those holdings and buy lower risk government bonds.
Higher quality blue chip companies are paying between 2% and 4% dividends. If investors are offered the opportunity to snag the same rate with less risk, some will. And if those investors sell those dividend stocks to buy the bonds when rates increase, the stock prices could drop. If your ETF holds those stocks, the value of the ETF could get roughed up.
2. Market Risk
As I said above, some high quality blue chips are paying 2% to 4%. But there are other dividend paying stocks which pay much higher rates and many dividend ETFs own both kinds of stocks.
Good examples of these dividend stocks are Master Limited Partnerships (MLPs) and Real Estate Investment Trusts (Reits). Many of these stocks pay 7% or more.
While the blue chip stocks pay dividends almost as a side component, the lion’s share of the return offered by MLPs and REITs is the dividend. But if these companies run into financial hardship and reduce or suspend their dividend, their share price could sink like a stone. Even if the underlying business remains solid, these companies are highly interest-rate sensitive. If rates go up, so do their costs. And if their costs increase, they may not have the cash to pay those fat dividends. In short, if rates go up, they could clobbered too – and so will the ETFs which hold them.
3. Restricted Growth and Income
Some people feel that the only way to squeeze income out of ETFs or funds is by owning dividend paying securities but that’s just not true. You can buy equity funds that pay no dividend and still create monthly income from those investments.
Why restrict your holdings to only those which pay dividends? I’m not saying you should necessarily rule these funds out, but I urge you to evaluate your holdings based on total return potential and risk rather than just making a buy/no buy decision based on the dividends alone.
Higher paying dividends often come from defensive sectors of the economy and they may not grow as much as other companies might if the economy continues to improve. Companies which forgo the dividend payout are able to invest that money in themselves. If they are solid companies, that growth can translate into higher share prices. And if you own companies like that, your account can potentially grow faster while still providing solid income.
High dividend ETFs might be appropriate for part of your portfolio but please evaluate these investments more globally. Consider the risks you take and the potential gains. Then, as always, compare this opportunity to other alternatives. If you are trying to maximize your long-term income potential, these ETFs might not always be your best choice.