Look Forward, Not Backward, With Dividend ETFs

There are two certainties in life, death and taxes, and there are two certainties when it comes to income investing. First, dividends are great. Second, steadily rising dividends are even better.

Simple math dictates that, over long-term time frames, stocks exhibiting positive dividend growth trends stand a good chance of outperforming those that do not ratchet dividends higher.

Perhaps that explains why so many investors look for dividend growth with ETFs. Several marquee payout funds, including the largest, the Vanguard Dividend Appreciation ETF (NYSE:VIG), use length of dividend increase streaks as a primary weighting criteria.

It pays to remember that evaluating a factor such as dividend increase streaks is a backward-looking endeavor and may not be the most efficacious strategy for finding the best dividend ETFs.

"Companies with a long history of dividend growth may not be the key drivers of tomorrow's dividend growth," said WisdomTree Research Director Jeremy Schwartz in a new research note. "We believe one has to be more dynamic in one's selection criteria to capture the current shifting trend in the U.S. dividend market."

Returns suggest investors can win with ETFs that focus on dividend increase streaks and those funds that feature alternative weighting methodologies. For example, the iShares Dow Jones Select Dividend Index Fund (NYSE:DVY) and the SPDR S&P Dividend ETF (NYSE:SDY) are up 18.1 percent and 21.1 percent, respectively, year-to-date.

DVY tracks the Dow Jones U.S. Select Dividend Index, which excludes companies with any negative dividend action in the past five yeas. SDY, the second-largest dividend ETF by assets, tracks the S&P High Yield Dividend Aristocrats Index (SPHYDATR), which requires constituent companies to have raised dividends for at least 25 consecutive years.

"Counterintuitively, the backward-looking dividend growth screens can actually be counterproductive for capturing the changing broader dividend growth of all dividend payers," said Schwartz in the note.

Over long-term holding periods, which are used by many income investors, other weighting strategies have proven more effective with dividend ETFs. For example, the WisdomTree Total Dividend Fund (NYSE:DTD) has gained 62.9 percent in the past three years, outperforming SDY by 550 basis points along the way.

DTD tracks dividend-weighted index that is built to reflect the proportionate share of the aggregate cash dividends each component company is projected to pay in the coming year, based on the most recently declared dividend per share, according to WisdomTree.

The WisdomTree Equity Income Fund (NYSE:DHS) has a similar weighting scheme and that ETF has returned a stellar 75 percent in the past three years. DHS does allocate more than 30 percent of its combined weight to health care and staples names, but the fund also features an almost 12 percent allocation to technology. Technology is now the largest dividend-paying sector in the U.S., but the group is chock full of new dividend payers, Apple (NASDAQ:AAPL) for example, and that precludes other dividend ETFs from having notable tech exposure.

"The requirement for historical dividend increases keeps the very firms currently driving the fastest dividend growth out of many of these indexes," said Schwartz.

Said another way, investors looking for capital appreciation and dividend growth may want to consider alternatives to dividend increase streaks when it comes to ETFs.

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