How to Develop a Portfolio of Dividend ETFs

Exchange traded funds have gained popularity in recent years.

Exchange traded funds, or ETFs, are investment companies that sell baskets of securities that belong to a specific index or represent a specific segment of the market. ETFs include funds that invest in indices such as the S&P 500, in sectors such as precious metals, and in stocks with high dividend yields.

Instructions

1. Search for ETFs that invest in companies that pay out dividends. Search business sites, such as Bloomberg or Morningstar, for information on which ETFs follow a dividend paying investment strategy. Many of these business sites have sections dedicated exclusively to ETFs; they include specific financial data on ETFs along with analyst commentary and suggestions. ETFs investing in dividend paying stocks are varied; some may invest in domestic companies, foreign companies, or both. Some ETFs may purposely avoid certain sectors and/or focus on companies that have a history of increasing dividends over the previous 10 years. There is wide variety in ETFs; closely evaluate your investment goals and the ETF's investment strategy.

2. Decide whether you value consistency in dividend payments or high dividend returns. Some ETFs may focus on companies that offer a consistent income stream regardless of the actual dividend yield or return. Look for ETFs that follow a dividend related index and have holdings of companies that have a history of dividend payments in consecutive periods. ETFs favoring consistent distributions tend to have holdings in large cap stocks such as Chevron, Walmart, and Proctor and Gamble. Some ETFs focus on companies that offer high returns even if payments aren't consistently made. Look for ETFs with high dividend yields and holdings in domestic and foreign companies for higher returns over consistent payments.

3. Don't forget about risk. Risk and volatility of the ETF is a primary concern for any investor. One measure of risk is the ETF's beta, which compares fund volatility to market volatility. Funds with betas greater than one tend to have higher volatility and returns. Some financial sites, such as Morningstar, designate ETFs as having "average" or "above average" risk using their own risk methodology. The standard deviation is also a measure of risk; the higher the number, the more volatile the ETF. The investor's return requirements for the risk involved in the investment should align with those of the ETF.

4. Analyze an ETF's performance over time. Evaluate an ETF's financial data, such as year-to-date return and net asset value. When analyzing performance, make certain to look at the individual securities that make up the ETF, especially those that are in the fund's major asset classes. The websites mentioned in Step 1 also contain performance data and offer ETF analysts' commentary that's useful to investors. Generally, companies that are expected to perform well in the future tend to have a strong past performance record. But don't lose sight of newer companies with a high income potential in their respective markets.

Tips & Warnings

• ETFs are not recommended for investors who engage in dollar cost averaging (making small, timely payments to build a portfolio).

References

• ETF db; Details of Dividend ETFs: Consistency vs. Yield; Michael Johnston; July 27, 2011
• The Motley Fool: Exchange Traded Funds -- A 60 Second Guide
• Morningstar: ETF Solutions -- Anatomy of an ETF

Resources

• Seeking Alpha; Five High-Yield Dividend ETFs for Smart Income Seekers; Feb. 18, 2011
• Bloomberg
• Morningstar