If you haven't thought about creating a durable income stream via high-quality, dividend-paying securities as part of your overall investment strategy, now would be a good time to start.
Building a portfolio around companies that pay dividends makes a great deal of sense.
Picking individual stocks can be hard, and stocks come with all kinds of risks - from dividend cuts to accounting irregularities to disruptive business changes, etc. A bigger basket of stocks, in the form of dividend-focused ETFs, can generate substantial income and allow you to sleep better at night.
Most dividend-paying ETFs hold stable, mature companies with solid cash flows, thus providing greater stability, income and safety in turbulent market conditions. Generating sustainable income from equities is not about just picking several of the highest-yielding stocks, but rather building a well-diversified, high-quality portfolio, which should include dividends from a variety of sources.
Here are five equity ETFs for a more stable income stream:
First Trust Morningstar Dividend Leaders Index ETF (FDL)
This ETF tracks the Morningstar Dividend Leaders Index, which is a modified market capitalization weighted index of publicly traded companies that have shown dividend consistency and dividend sustainability. FDL maintains a portfolio of about 100 stocks, with nearly two-thirds of assets lying in the top-ten holdings. The Consumer Staples sector has the greatest weighting, representing 22.47% of the fund. The Utilities sector follows, with a 21.01% weighting. The fund's top three holdings include Exxon Mobile (XOM), AT&T (T) and Verizon Communications (VZ). FDL's annual expense ratio comes in at 0.45% and its current dividend yield is 3.61%.
Utilities Select Sector SPDR ETF (XLU)
There's a good chance you don't have much exposure to the utility sector. After a stellar +27% return in 2014, Utility ETFs declined by -7.5% in 2015 as many investors bailed on interest-sensitive securities ahead of the Federal Reserve's first interest rate hike. But their relative strength in an awful market, and low interest rates, make a strong case for increased exposure in your portfolio.
The largest and most liquid Utilities ETF is the Utilities Select Sector SPDR ETF, which holds all 29 utilities firms found in the S&P 500 and yields 3.50%. XLU's top 10 holdings make up slightly more than 60% of assets. Its largest holdings include NextEra Energy (NEE): 9.1% of assets, Duke Energy (DUK): 8.5% of assets and Southern Company (SO): 7.94% of assets. XLU charges an annual fee of 0.14%.
PowerShares S&P 500 High Dividend Low Volatility ETF (SPHD)
There is extensive historical evidence supporting a low-volatility approach to equity investing. The PowerShares S&P 500 High Dividend Low Volatility ETF adds a twist to the low-volatility approach by cherry-picking stocks that have both high dividends and low volatility.
It tracks the S&P 500 Low Volatility High Dividend Index which is composed of 50 securities traded on the S&P 500 Index that historically have provided high dividend yields and low volatility. The largest weighting is the Utilities sector, which represents almost 20% of the portfolio. SPHD's largest holdings are CenturyLink (CTL), Iron Mountain (IRM) and Spectra Energy (SE). This ETF is an attractive option for investors who are looking for ways to minimize market turbulence while earning relatively attractive dividends. It yields 3.57% and comes with a 0.30% annual expense ratio.
Market Vectors Preferred Securities ex-Financials ETF (PFXF)
Investors in the Market Vectors Preferred Securities ex-Financials ETF reap yields of around 6% along with advantageous tax treatment on distributions.
Preferred stock is a hybrid and has characteristics of both a bond and a stock. Like stocks, preferreds trade daily on an exchange. Like bonds, they pay fixed income on a regular basis (usually quarterly) and do not benefit from earnings growth of the issuing company. They also have higher dividend yields than most stocks and bonds. In the capital structure, preferred stock is senior to common stock but junior to corporate bonds, and preferred shareholders have no voting rights.
PFXF tracks the performance of the Wells Fargo Hybrid and Preferred Securities ex-Financials Index. The index is comprised of convertible and non-convertible preferred securities listed on U.S. exchanges. The largest percentage holdings include 39.60% in Utilities and 33.50% in REITs. The Financial Services sector only makes up 4.30% of the portfolio. PFXF charges an annual fee of 0.40%.
The tax treatment of preferred stock can vary; PFXF's dividends have resulted in its investors usually paying qualified rates on about 20% of dividends, ordinary income on the remainder, and capital gains (or losses) on any sales of PFXF.
The three largest preferred ETFs: the iShares U.S. Preferred Stock ETF (PFF), the PowerShares Preferred Portfolio ETF (PGX) and the First Trust Preferred Securities and Income ETF (FPE) offer more in the way of qualified dividends, however, they also hold a big percentage of financial services companies (80% or more) in their portfolios. While many investors may want that kind of exposure, you should know that the banking sector saw massive selling of its preferred stock, bonds and equities during the financial crisis in 2008. Banks, right now, are under pressure across the globe, falling between -25% and -50% during the last several months, something we have not seen since the 2008-2009 bear market.
iShares Residential Real Estate Capped ETF (REZ)
With more people renting than ever, investors can capitalize on the trend through residential real estate investment trusts. Yields on REITs are typically high, as they are required by law to pay out 90 percent of their taxable income as dividends to shareholders.
The iShares Residential Real Estate Capped ETF is a solid choice, as rent prices rise and Americans are forced to push aside new home purchases. It began trading in May 2007, and tracks the price and yield performance of the FTSE National Association of Real Estate Investment Trusts All Residential Capped Index.
Almost 50% of the fund's holdings include residential REITs, such as Equity Residential REIT (EQR), along with positions in healthcare like Welltower (HCN) and self-storage real estate stocks including Public Storage (PSA). REZ offers a compelling strategy for investors looking to focus in on the residential corner of the U.S. REIT market.
There are plenty of ways to generate income in your portfolio. However, if you are seeking some relatively stable options as part of your overall strategy, you may want to take a closer look at some of the more durable, dividend-focused ETFs.
Dividend-paying ETFs can provide you with a safer, more sustainable income stream, especially in challenging market conditions.
Disclaimer: George Kiraly Jr., CFP®, MBA is the president of LodeStar Advisory Group, LLC, an independent Registered Investment Adviser located in Short Hills, New Jersey. George Kiraly, LodeStar Advisory Group, and/or its clients may hold positions in the ETFs, mutual funds and/or any investment asset mentioned above. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.