It's not just that dividends from some foreign companies, most partnerships, and much of the payout from real estate investment trusts don't qualify for the tax break. Suppose you owned Merck (MRK
), a 4.6% yielder that hit plenty of bumps last year. If you held a steady position in it, no problem. But suppose you simply traded in and out a bit. Then you may have fallen into a 60-day holding-period trap for the time around dividend payments. Some dividends would qualify for the lower rate, some would not, and the onus would be on you to sort it out. (Rules: Internal Revenue Service Publication 550 or irs.gov/businesses/small/article/0,,id=122523,00.html.)
Ugh. This is part of why two exchange-traded funds, or ETFs, that track indexes of high-yielding stocks are taking in money fast. Barclays Global Investors (BCS
) introduced its iShares Dow Jones Select Dividend Index Fund (DVY
) in November, 2003. It now boasts more than $6.1 billion in assets. Last December it got a direct rival in PowerShares High Yield Equity Dividend Achievers Portfolio (PEY
), which already has drawn assets of nearly $500 million. Either is a reasonable alternative to running your own dividend-stock portfolio or to a traditional mutual fund focusing on income, such as Washington Mutual Investors Fund (yield: 2%). They pay more than most traditional funds, notes Dan Culloton, a Morningstar analyst, and they're cheaper (table).
Yet they are not without risks, including greater-than-average exposure to particular industries, such as utilities. Seven of the PowerShares fund's top 10 current holdings are utilities. With 100 companies rather than PowerShares' 50, the iShares fund is less concentrated in any particular sector. But it still owes plenty of its yield to financial stocks, such as Bank of America (BAC
), which are vulnerable to rising interest rates. Another danger: the chance investors will be less charmed by dividend-payers tomorrow than they were yesterday. In 2004 the iShares ETF returned 17.9%, seven percentage points more than the Standard & Poor's 500-stock index (MHP
). This year its total return is a negative 2.3%, a bit worse than the index. The PowerShares fund is off quite a bit more.
The rudest shock could come at tax time. It turns out that not all of the dividends from these funds necessarily will pass Uncle Sam's scrutiny as qualified. When the funds periodically trade shares to get back in line with their indexes, they may run afoul of holding-period rules. This is why the iShares fund's 2004 distributions of $1.91 per share included 28 cents of nonqualified income -- a fact surprising even to John Prestbo, editor of Dow Jones Indexes (DJ
), creator of the index the iShares fund tracks.
How much nonqualified dividends would hurt depends, naturally, on how much money you have in one of these funds and your tax situation. An investor in the 35% income-tax bracket who had put $100,000 into the iShares fund at the start of 2004 would have seen a pretax dividend yield of 3.6% and an aftertax yield of 2.9%. Had all of the dividends qualified for the 15% tax rate, the aftertax yield would have been a bit over 3%.
So these funds aren't perfect. That said, for income-seeking investors with little time to manage their own portfolios, they look to me like a neat solution. By Robert Barker