Dividend ETFs Face Bubble Talk

Until recently, investors have embraced, low-beta, high dividend sectors as a way of participating in the broader market's rally to new highs. The proof is in the pudding.

In April alone, dividend/income ETFs attracted $3.4 billion in new assets to bring the group's year-to-date total to $10.9 billion, according to BlackRock.

In terms of individual ETFs, the Vanguard Dividend Appreciation ETF (NYSE:VIG) has impressed with 2013 inflows of $2.1 billion while the SPDR S&P Dividend ETF (NYSE:SDY) has drawn in over $1 billion in new assets.

Then there are sector-level returns. Through the end of April, the four best performing sectors this year were utilities (up 19.7 percent), health care (up 19.2 percent), consumer staples (up 18.1 percent) and telecommunications (up 17.1 percent). All of that is enough to make investors believe the dividend bubble talk that has started to recently pick up.

Talk of a dividend bubble, in part, comes by way of what some analysts and investors view as frothy valuations on some dividend sectors. With the S&P 500 Utilities Index sporting a P/E ratio of 15.9, utilities stand as a richly valued group, but that does not mean all dividend sectors.

"To the contrary, we think dividend stocks in aggregate are attractively priced," said WisdomTree Research Director Jeremy Schwartz in a new research note.

Telecom sports valuations that can be considered with the S&P 500 Telecommunications Index showing a P/E ratio of 20.5 at the end of April, but the equivalent staples and health care indexes are not excessively values, as WisdomTree data indicate.

Importantly, investors do have options if they are looking to avoid dividend sectors that may be showing signs of bubbles ahead or imminent declines. Perhaps due to a screening methodology that includes only those stocks that have raised dividends for at least 25 straight years, the SPDR S&P Dividend ETF allocates over 10 percent of its weight to the utilities sector. The WisdomTree LargeCap Dividend Fund (NYSE:DLN) only has a 5.7 weight to utilities and DLN's index, the WisdomTree LargeCap Dividend Index, has a lower P/E ratio at 13.8 than the S&P 5000 at 14.1.

Over the past three years, DLN has outperformed SDY by 670 basis points while being slightly less volatile.

"I would argue that analysts are drawing a misguided conclusion about dividend stock valuations by just looking at these particular higher-dividend sectors. When one looks at diversified baskets of dividend stocks across all market sectors, the valuation picture changes," said Schwartz.

There is something to be said for diversity. While the WisdomTree Equity Income Fund (NYSE:DHS) allocates 12.8 percent of its weight to utilities and 11.8 percent to telecom, four other sectors also receive double-digit allocations in that ETF. That group includes, technology, which is the fastest-growing dividend sector in the U.S.

DHS, which like DLN pays a monthly dividend, tracks the WisdomTree Equity Income Index. That index has a P/E of 14.7, just above the S&P 500's, and a dividend yield that is nearly double the benchmark U.S. index.

Additionally, DHS has outperformed SDY and VIG by 1,760 and 2,160 basis points over the past three years while being noticeably less volatile than those funds. Neither SDY nor VIG pays a monthly dividend, either. Importantly, there is also something to be said for potential dividend growth going forward over backward-looking dividend increase streaks.

"Given the lower dividend payout ratios (and higher reinvestment in the company or use of cash to fund stock buybacks), it should not come as a surprise that high-yielding dividend payers had lower growth expectations than the potential dividend growers," said Schwartz. "Given similar price-to-earnings ratios, many might view the potential dividend growers as being more attractively priced, given their higher growth expectations."

For more on ETFs, click here.