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Income ETFs Not Offering Much Useful Income

Investors seeking a sensible combination of safety and income have naturally gravitated toward income ETFs. These funds buy higher-yielding stocks and seek to provide investors with a solid income while mitigating the fluctuations of individual stock investments.

Of course, there’s one problem: As the market has continued to rise, income ETFs have ceased to provide a decent income. In fact, it’s tough for income ETFs to achieve yields much above 3% these days.

Even the ProShares S&P 500 Dividend Aristocrats ETF (NOBL), which invests in companies that have increased their dividends for 25 consecutive years or more, yields a measly 1.6%. Thus, in spite of the fact that I’m a believer in the “Dividend Aristocrat” style of investing – which tends to lead you to the most stable companies with the best long-term track records – the current yield simply doesn’t represent a good value.

What, then, are income investors supposed to do?

First of all, it’s worth noting that two factors have made income ETFs less attractive: stock prices and share buybacks.

The market has risen 150% from its low in 2009 and is now some 30% above its 2007 high. Naturally, that caused dividend yields to decline. At the same time, companies have increasingly taken to repurchasing shares instead of paying out dividends, and this is an unattractive development.

You see, ordinary shareholders get very little benefit from share repurchases because the company buys shares either in the market or from institutions, not by making a general tender. Additionally, corporate managements have a conflict of interest: Dividends reduce the value of their stock options while stock repurchases increase them.

Finally, companies buy back more shares when they have more money – i.e., when times are good – and then often resort to emergency and highly dilutive share issues in the next downturn. Buying high and selling low is never a good policy.

Today, the combination of rising values and declining payouts has lowered the yield on the Standard and Poor’s 500 Index to 1.9%. That’s not going to pay for much of a retirement. Meanwhile, the market is moderately overvalued in terms of earnings, with the S&P 500 standing on a price-to-earnings (P/E) ratio of 19.4x. Yet with dividend payouts averaging only 38% of earnings, yields are well below their long-term average, although not close to the 1.1% they touched at the peak of the 2000 boom.

Slim Pickings in the Dividend Universe

Clearly, it’s a tough environment for income right now. However, not all income ETFs are a total bust.

Indeed, more yield-aggressive ETFs are doing somewhat better. For example, the RevenueShares Ultra Dividend ETF (RDIV) manages a yield of 3.2% by identifying the top 60 dividends in the S&P 500, and then investing up to 20% of the fund in shares outside the S&P 500. This seems like a reasonable approach, but once again, it says much for the market’s toppiness that even this “ultra” approach only gets you as far as a 3.2% yield.

The best yield I found among the S&P 500-related dividend funds was the 3.3% achieved by the PowerShares S&P 500 High Dividend ETF (SPHD). That fund seeks to match the return of the S&P 500 Low Volatility High Dividend Index, a fund selected by Standard and Poor’s that consists of the 50 index constituents with low volatility and the highest historical dividend yields.

Once you go beyond the S&P 500, you can do better by investing in a specialized income ETF, albeit at the cost of taking on much more risk. For example, the Alerian MLP ETF (AMLP) manages a historic dividend yield of 6.7% by investing in the shares of energy master limited partnerships (MLPs). However, the catch here is that energy MLP dividends are being cut right and left due to oil’s decline. For that reason, the historic 6.7% yield is a poor guide to the yield going forward.

Bonds aren’t a better alternative, either. In conventional bonds, a typical medium-term bond fund, the iShares iBonds March 2023 Corporate ETF (IBDD), yields just 3.2%, no better than the best dividend ETFs. And while investors can achieve higher yields with high-yield bonds, they also make themselves extremely vulnerable to an economic downturn, since the loss rate on those bonds will be very high when hard times recur. This is particularly true in the energy sector, which saw rampant high-yield bond financing when the price of oil was $100.

There is, however, one other avenue to pursue – preferred stock. Preferred stock, unlike common stock, pays a fixed dividend, but has the right to receive dividends ahead of common stockholders. Because preferred dividends aren’t tax deductible, this form of financing has fallen out of fashion in recent years. However, with individual preferred stock issues being illiquid, an ETF is the ideal way to gain exposure to this sector.

The Market Vectors Preferred Securities Ex-Financials ETF (PFXF) yields a chunky 5.6% and is far less vulnerable to a stock market decline than a common stock fund. Even though a major recession would cause some of its constituents to stop paying dividends, many preferred stock issues are cumulative, so those companies surviving the recession would be forced to make up unpaid preferred dividends before paying dividends on their common stock. For income investors, this preferred stock fund may prove to be a fairly safe haven in a difficult market.

Good investing,

Martin Hutchinson

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