A new dividend-oriented investment

A new investment product is on the horizon that will allow investors to implement a high-yielding equity strategy with minimal costs.

Marvin Appel, PhD, and Brian Hufford, CPA

A new investment product is on the horizon that will allow investors to implement a high-yielding equity strategy with minimal costs. In November 2003, Barclays Global Investors launched the first dividend-oriented, exchange-traded fund (ETF) — the Dow Jones Select Dividend Index Fund, ticker symbol DVY. There are reasons to expect this could be a promising investment.

ETFs are mutual funds that hold baskets of stocks with the goal of tracking the movement of specific market indexes. Unlike traditional open-end mutual funds, ETFs are traded throughout the day on exchanges in the same way as shares of stocks.

The DVY holds the basket of stocks that comprise the Dow Jones Select Dividend Index. This index consists of the 50 U.S. stocks with the highest dividend yields that also meet three other criteria:

1) Five consecutive years of increasing dividend payouts
2) Five-year average payout ratio of 60 percent or less. (That is, stocks in companies whose dividend payouts consumed at most 60 percent of after-tax earnings. The lower the payout ratio, the more secure the dividend payout appears.)
3) Average daily trading volume of $1.5 million. (This is not a very stringent criterion and allows stocks in small- and medium-sized companies to be in the Select Dividend Index.)

The Select Dividend Index has been yielding approximately 4 percent per year, similar to the dividend income from the 10-stock strategy. The expenses you incur when buying DVY include the costs of a single transaction and the ETFs annual expense ratio of 0.4 percent. (As with traditional open-end mutual funds, ETFs have expense ratios. ETF expense ratios are generally smaller than the overhead in most open-end funds with similar objectives.)

Taking into account the 0.4 percent annual expense ratio of the DVY results in an expected dividend yield of 3.6 percent. This yield is well above the yields of less than 2 percent available from ETFs that track widely followed market benchmarks, such as the S&P 500 or the Dow Jones Industrial Average.

The DVY may be safer during a market correction

Historically, stocks with above-average dividends as a group have held their values better during bear markets than the market overall. Although I do not expect a serious market correction before the November election, historical precedent suggests that stocks could be in for a pullback during the 2005 to 2006 period.

Over the past 10 years, the Select Dividend Index has slightly outperformed the Dow Jones Industrial Average. Although future results cannot be predicted, the potential implication is that the DVY should roughly match gains in the Dow industrials during future bull market periods.

Stock dividends are now very competitive with bond yields under the new tax law

A 3.6 percent dividend yield taxed at 15 percent (the top federal long-term capital gains tax rate) offers the same after-tax return as a bond yield of 4.7 percent taxed at 35 percent (the top ordinary income rate). Given that intermediate term, investment-grade corporate bonds currently yield 4.5 to 5 percent on an after-tax basis, the DVY currently generates a level of investment income similar to what is available from portfolios of individual bonds and produces greater interest income than most investment-grade bond mutual funds.

Individual investment-grade corporate bonds do have the advantage that the return of principal at maturity is virtually guaranteed, whereas no such guarantee exists for the performance of the DVY or of any other equity investment, nor of bond mutual funds. However, compared to bond investments, the DVY has the advantage of a potentially growing stream of investment income whenever the underlying companies increase their dividend payouts. The DVY also has far greater liquidity than individual corporate bonds.

In conclusion, the DVY may be an excellent investment as part of a program to produce current investment income, or as a potentially defensive stock market strategy.

Dr. Marvin Appel is CEO of Appel Asset Management. He holds a degree in biochemical sciences from Harvard College and earned his MD in 1991. He is coauthor of Systems and Forecasts. Contact him at (516) 487-7146 or mappel@appelasset.com. Brian C. Hufford, CPA, CFP, is president of Hufford Investment Advisory Programs, LLC, and Hufford Financial Advisors, companies dedicated solely to helping dentists secure solid financial planning and safe investment strategies. He can be reached at (317) 848-4987.

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