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Dividend-paying funds can cushion blows from a brutal market

Apr 22, 2008 Market Outlook

NEW YORK (MarketWatch) — Dividend-paying stocks are supposed to suffer less in a
market downturn, precisely because of their cash payouts. So, how are they doing
in the current rough patch?

Short answer: Worse than the overall market last fall, but a whisker better so
far this year.

As proxies for all dividend-paying equities, we are using a few of the dividend
indexes that mushroomed after the federal tax rate was lowered on most dividend
income in 2003. A recent download from IndexUniverse.com turned up 32 of them,
each underlying a U.S.-listed exchange-traded fund.

Through April 11, the Dow Jones Wilshire 5000 Index was down 14.05% on a total
return basis from its record high on Oct. 9, 2007, and is off 8.67% this year
alone. By contrast, the Dow Jones Select Dividend Index fell 17.02% and 8.58% in
those two periods.

It wasn’t that way during the previous big skid. While the DJ Wilshire 5000 was
sinking 48.61% from a peak on March 24, 2000, to its nadir on Oct. 9, 2002, the
DJ Select Dividend Index (on a back-tested basis because it was launched Nov. 3,
2003) gained 19.11%.

The difference is that the earlier bear market was basically a tech and telecom
belly flop, and those companies tend to pay small dividends, if any. Tech and
telecom got hammered this time around, too; but it was the swoon of
credit-crunched financial stocks that hit the dividend indexes particularly hard.

Banks, insurers and other financial firms tend to pay plump dividends. The yield
on the Dow Jones Wilshire Financials Index was 3.24% last Dec. 31, compared to
1.83% for the DJ Wilshire 5000. That yield for Financials was the second highest
among all 10 industry groups. (Telecommunications was the highest with a yield of
3.40% and Utilities was 2.86%.) Of course, the more share prices are beaten down,
the higher the yield climbs, assuming the dividends are maintained and not cut.

Yield signs

The DJ Select Dividend Index, which underlies the iShares fund of the same name
(DVY) is very heavily (50.1%) into Financials, which is its largest industry
group. This index is weighted not by market value of the stocks but rather by
their annual cash payouts as a percentage of the total disbursement of all 100
components — another factor contributing to Financials’ weight.

Other dividend indexes are in similar if not as extreme circumstances. Financials
constitute 38% of the Standard & Poor’s High Yield Dividend Aristocrats index,
which has 50 stocks and underlies the SPDR S&P Dividend ETF (SDY), and 43.7% of
the Wisdom Tree Dividend Top 100 Index, which underlies the Wisdom Tree ETF of
the same name (DTN).

Some dividend indexes force diversification away from Financials, but this
benefit isn’t free. One of these is the Vanguard Dividend Appreciation VIPER
(VIG), which is based on a customized version of the Mergent Dividend Achievers
Index. As of Feb. 29, this ETF was just 13.6% in Financials, down from 20.6% a
year earlier and below the underlying index’s 15.6% weight in that industry.

As a result, this ETF on April 11 was priced just 1.7% lower than it had been on
Oct. 9 of last year, and was off 5.1% thus far this year — a much better
performance than either DJ Select Dividend or the S&P High Yield Dividend
Aristocrats index. On the other hand, its yield on March 31 was less than half
(1.72%) of the DJ Select Dividend (4.29%) and S&P Aristocrats (4.0%).

Another difference among dividend indexes is when they drop stocks. DJ Select
Dividend, for example, boots a stock immediately if the company eliminates its
dividend or lowers its dividend to the point that its new yield is less than that
of the lowest-yielding non-component on the latest monthly selection list. The
booted stock is replaced by the non-component with the highest indicated annual
yield.

Since the annual review of the index last December, three components have been
replaced: La-Z-Boy Inc. (LZB), PFF Bancorp, Inc. (PFB), and Washington Mutual
Inc. (WM) were all dropped due to dividend cuts or, in PFF’s case, a suspension.

The replacements were Mercury General Corp. (MCY), Marshall & Ilsley Corp. (MI),
and First Community Bancorp Inc. ((FCBP)

The Wisdom Tree Dividend Top 100 Index deletes stocks whose dividends have been
eliminated, but keeps those with reduced dividends until the next annual review.
The S&P Dividend Aristocrats removes stocks only at the annual review, unless a
component stock ceases being a component of the S&P 1500. Thus, Washington
Mutual’s 93% dividend cut this month caused the stock to be removed from DJ
Select Dividend but it remains in the Wisdom Tree index (Washington Mutual isn’t
in the S&P index, so there was no effect.)

National City Corp. (NCC) also slashed its dividend, and DJ Select Dividend will
toss it out after the close on April 23. National City also is in the Wisdom Tree
Dividend Top 100 but not the S&P index.

One more detail to consider: Some of the dividend indexes include real estate
investment trusts — the Wisdom Tree Dividend Top 100, for instance - and others
exclude them. That’s important to know because REIT dividends don’t qualify for
the lower federal tax rate that is applied to corporate dividends.

Global payout

Non-U.S. dividend indexes and funds are popular now because the sinking value of
the dollar (down 7.8% against the euro and 9.5% against the yen this year through
April 11) means foreign dividend payments are worth more in dollars. As a result,
the yields on ex.-U.S. dividend indexes are significantly higher than those of
their domestic counterparts.

For example, the Dow Jones EPAC Select Dividend Index had a yield on April 11 of
6.59% vs. 4.90% for the domestic equivalent. It underlies the iShares DJ EPAC
Select Dividend ETF (IDV). The Wisdom Tree International Dividend Top 100 Index,
which underlies the similarly named ETF (DOO), has a yield of 5.45%, versus 5.1%
for the domestic version.

In terms of performance, the Wisdom Tree ETF lost 9.28% on a total return basis
in the first quarter, while the iShares ETF fell 7.78%. In the same period, the
Dow Jones Wilshire ex-U.S. Index retreated 9.22%. By the way, not all ex-U.S.
stocks’ dividends qualify for the lower federal tax rate, but most that are in
these funds do.

So, while dividend indexes and the funds based upon them don’t necessarily
insulate you completely from market declines, they usually cushion the fall. The
typical concentration in the Financials industry is an extra drag currently.
Someday, though, today’s losses will be compensated as these stocks revert to
average performance.

No, I don’t know when that will happen.

If you’re inclined to take the plunge now, spend some time getting to know the
indexes and funds you are considering or that are recommended to you. Issues such
as whether REITs are included and how dividend-cutters are treated could make a
difference in your after-tax total return.

In other words, don’t shop by yield alone.

Remember, once you have put you investment money to work in a dividend fund you
have locked in your yield. After that, what is important to you is not yield but
payouts. Funds post their recent distributions on their Web sites, and that will
tell you just how often the cash register will ring for you.

John Prestbo is editor and executive director of Dow Jones Indexes, a unit of
News Corp., publisher of MarketWatch. Radhika Uppalapati contributed research to
this report.

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