Dividend ETFs: No Need to Pay up For Yield

Although concerns about rising interest rates have spiked in recent weeks, investors still want yield. Now, it is a matter of what asset classes they turn to in an effort to generate income.

Yields on 10-year Treasurys were 2.19 percent as of Monday, up from 2.13 percent on June 3, according to Treasury Department data, but the reality is even at 2.2 percent, the yield on Treasurys is nothing to write home about.

Given the still anemic yields on assets that are perceived to be risk-free, it is not surprising that investors have been paying up for higher yields elsewhere. The ongoing hunt for yield has predictably prompted talk of a dividend bubble, particularly as valuations on some favorite dividend sectors have become stretched.

"A number of analysts believe dividend-paying stocks with the highest dividend yields are expensive compared to other parts of the equity market. A rise in the long-term interest rates in the U.S. put some pressure on the performance of stocks with the highest dividend yields in May," said WisdomTree Research Director Jeremy Schwartz in a research note.

Said another way, investors may want to consider different spins on dividend ETFs rather than paying up for yield with traditional sector and dividend funds. For example, the Utilities Select Sector SPDR (NYSE:XLU), despite an unusual bout of weakness over the past month, still trades with a P/E ratio of almost 15.6. That is toward the higher end of the sector's historical valuation, but investors still love the the 3.85 percent dividend yield.

Same thing goes for the Consumer Staples Select Sector SPDR (NYSE:XLP). A 2.35 dividend yield is still better than Treasurys and just a few extra basis points difference leads to a P/E of almost 18.

These elevated valuations also indicate that investors are willing to pay up for dividend growth, or more specifically, a stock's past track record of increasing payouts. Combine the hunt for yield with adulation for dividend increase streaks and it is not surprising that investors are enamored by ETFs such as the Vanguard High Dividend Yield Indx ETF (NYSE:VYM) and the SPDR S&P Dividend ETF (NYSE:SDY).

However, the stretched valuations indicate investors should want more than high yields. Additionally, the backward-looking nature of past dividend increases and the emphasis by some ETFs on that theme could put investors in a position where they are missing out on future sources of dividend growth.

A Solution The newly minted WisdomTree U.S. Dividend Growth Fund (NASDAQ:DGRW) could be one ETF that solves conundrum of not paying up for dividend growth while offering investors exposure to potentially robust sources of future payout increases.

DGRW is not yet a month old, but the fund has already accumulated almost $15 million in assets under management with an annual fee of 0.28 percent. More important than superficial statistics is DGRW's sector exposure, which features an almost 21 percent weight to technology.

For more than five years, tech has been a pivotal driver of U.S. dividend growth, yet some of the most popular dividend ETFs, such as those mentioned earlier in this piece, have scant allocations to the sector.

Importantly, investors do not have to pay up for access to tech dividends, as DGRW's underlying index, the WisdomTree U.S. Dividend Growth Index, proves.

"The WisdomTree U.S. Dividend Growth Index had long-term earnings growth expectations that were about 5 percentage points higher than those of the WisdomTree Equity Income Index, as of May 31, 2013. Simply put, this means that, relative to their P/E ratios, one is not paying a premium P/E multiple to get access to the higher long-term earnings growth expectations of the U.S. Dividend Growth index," said Schwartz.

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