Deriving the Most from Dividends


By Palash Ghosh Dividend-paying securities have become increasingly popular among investors for a number of reasons, including favorable tax rules and high-yielding equities' appeal as a safe haven during periods of market volatility.

Indeed, 1,745 dividend increases were reported in 2004, a 7.1% gain over 2003, according to Standard & Poor's data. In cash terms, U.S. companies paid out a record $181 billion in dividends, excluding Microsoft's (MSFT) gigantic $32.6 billion one-time payment. Howard Silverblatt, S&P market equity analyst, believes that with cash levels in S&P 500 stock index outfits at record highs, dividend payouts could rise by more than 12% in 2005.

ETF OPTIONS. Investors can exploit this dividend-paying frenzy through an array of high-yielding equity investment vehicles. These include equity-income funds such as Vanguard Equity Income (VEIPX) or Parnassus Equity Income Fund (PRBLX), which emphasize high-yield, large-cap value issues primarily, or through certain sector funds that focus exclusively on dividend-paying industries. Owning hand-picked individual stocks of dividend-paying companies directly is another option.

Sam Stovall, S&P's chief investment strategist, estimates that about 75% of S&P 500 concerns are currently paying dividends. He notes the highest yields tend to come from large-cap stocks with low price-to-book values in the financials, utilities, materials, energy, telecom services, and consumer staples sectors. Tobacco and real estate investment trusts (REITs) provide particularly rich payouts. As a whole, the S&P 500 recently yielded 1.94% on average.

However, in addition to dividend-yielding stocks and equity-income mutual funds, investors may also consider putting their money into certain exchange-traded funds (ETFs) designed to generate high dividend yields. The iShares Dow Jones Select Dividend (DVY), for instance, is essentially a basket of dividend-paying stocks that can be bought in a single clip. Though still in its infancy, the ETF industry has mushroomed into a $212 billion business in little more than a decade.

MORE TAX EFFICIENT. ETFs can be bought and sold like stocks throughout the day. As a result, they provide the ease, flexibility, liquidity, and continuous pricing of owning individual stocks -- with the diversification of index funds, notes Srikant Dash, equity index strategist at S&P. Moreover, ETFs typically feature much lower management fees and expense ratios than more conventional mutual funds. "There's a wider variety of styles, size, and sector-specificity available in the ETF universe than in the open-end mutual fund format," Dash adds.

The Tax Relief Reconciliation Act of 2003, which essentially cut the maximum tax rate on dividends from 35% to 15% for most investors, also applies to payments distributed to shareholders by ETFs. (Investors should be aware that the new tax rate expires at the end of 2008, unless lawmakers can extend it.) Also, ETFs trade so infrequently that they incur low capital-gains distributions. In short, lower turnover makes ETFs more tax efficient than most actively managed mutual funds. That's especially important when they're held outside of defined contribution plans, such as 401(k)s.

One ETF drawback is the higher transaction fees and broker commissions they require, especially if traded frequently, Dash notes. However, any comparisons between ETFs and regular index mutual funds should involve the evaluation of a number of factors, including expense ratios, operating and management fees, investment objectives, and risk tolerance. In terms of monthly dollar-cost averaging small amounts of money, a low-fee mutual fund could be a better option in order to avoid excessive and repeated commissions.

UNIQUE SECURITY. The top-yielding ETF as of Dec. 31, 2004, the $533 million streetTRACKS Wilshire REIT Index Fund (RWR), invests in stocks of the underlying Wilshire benchmark index of REITs. These stocks, both in the index and in the ETF, are weighted according to market-cap size, says Fernando Diaz of the portfolio management team at State Street Global Advisors, which runs the fund. As a result, large-cap REITs dominate the portfolio, with the top 10 holdings accounting for 39% of total assets.

However, Diaz points out that REITs are a unique security. By law, they're required to distribute 90% of taxable income to shareholders. "REITs don't pay taxes at the corporate level, and that's why they generate such high yields," he explained. "Thus, dividend income from REITs may not be subject to the lower tax rate, although the capital-gains component of the dividend income does fall under the lower tax. Still, after taxes, REITs will still give you yields of 4% to 4.5%, which remains more attractive than the yield of the S&P 500."

But for investors seeking broader market exposure and diversification, the $5.3 billion iShares Dow Jones Select Dividend might make more sense. With a handsome 17.9% gain in 2004 and an expense ratio of 0.4%, this ETF invests in the 100 highest-yielding stocks (excluding REITs) of the Dow Jones U.S. Total Market Index. Not surprisingly, this portfolio has heavy exposure to financials and utilities, something to keep in mind if you already have a lot of representation in those sectors.

HIGHER PAYOUTS FROM OVERSEAS. Another dividend-focused ETF, the PowerShares High Yield Equity Dividend Achievers Portfolio (PEY) invests in 50 high-yielding stocks that have raised their annual distributions every year for at least 10 years. Unlike the Dow Jones ETF, stocks in the PowerShares are weighted according to their dividend yield, not by market-cap size. Launched just last month, the fund has already attracted more than $135 million in net assets and has a yield of about 3.5%, according to the company. This ETF is still too new to be ranked by S&P.

Foreign businesses tend to pay higher dividends than their U.S. counterparts, as illustrated by the presence of four overseas-focused ETFs in the table below: Singapore, Australia, Italy, and Pacific Rim, excluding Japan. However, buying a single-country ETF often doesn't afford the same diversity as investing in all sectors of the U.S., since single-country economies are generally much smaller and can be heavily weighted in one industry or sector.

TOP 10 EQUITY ETFs BY 12-MONTH DIVIDEND YIELD

ETF

Symbol

12-mo. Div. Yld. (12-31-04)

2004 Return

Exp. Ratio

streetTRACKS Wilshire REIT

RWR

5.00%

32.7%

0.26%

iShares Dow Jones U.S. Real Estate Index

IYR

4.22%

30.3%

0.60%

iShares Cohen & Steers Realty Majors Fund

ICF

4.16%

35.1%

0.35%

iShares MSCI Singapore Index

EWS

3.89%

22.6%

0.59%

iShares MSCI Australia Index

EWA

3.44%

30.8%

0.59%

iShares MSCI Pacific Index (Ex-Japan)

EPP

3.36%

28.6%

0.50%

S&P Select Utilities SPDR Fund

XLU

3.14%

23.3%

0.27%

iShares Dow Jones Select Dividend Index

DVY

3.11%

17.9%

0.40%

iShares Dow Jones U.S. Utilities Sector Index

IDU

2.83%

23.2%

0.60%

iShares MSCI Italy Index

EWI

2.51%

32.1%

0.59%

Source: Standard & Poor's. Total returns include reinvested dividends. Preliminary data as of 12/31/04. Ghosh is a reporter for Standard & Poor's Fund Advisor


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