Beware the Dividend ETF

In a market where nothing seems to work, many experts recommend dividend stocks as a refuge from the storm and a solid long-term holding. And investing in exchange-traded funds seems like an easy way to play: There are now some three dozen dividend ETFs, with a total of $8 billion in assets. That’s more than double the $3.8 billion in utilities ETFs, another safe-haven category.

But investors tempted to pick up a batch of dividend payers through an ETF could be in for an unpleasant surprise. Many of these funds have loaded up on some terrible performers: financial stocks. Historically, companies such as banks and insurance companies have paid some of the highest dividends around. Lately, the financial crisis has led many of these companies to slash their dividends — $35 billion worth in the first half of 2008 alone.

While some funds use dividend-coverage ratios to predict whether a company has enough earnings to pay its dividend, those measures “haven’t been working lately,” says Morningstar ETF analyst Scott Burns. Troubled financial firms often announce losses before they get around to cutting their dividends. The bad news can drive down the stock, making the dividend look high. Citigroup’s 16 cents-a-share quarterly dividend briefly translated into a 17% annual yield until the government bailed it out; now it pays just a penny.

Look for ETFs that re-evaluate their holdings often — and watch out for those weighted heavily in financials. The PowerShares High Yield Equity Dividend Achievers Fund (PEY) has 61% in financials, though a PowerShares spokesperson says that may change in January, when the index goes through its annual reconstituting. First Trust Value Line Dividend Index Fund (FVD) re-evaluates monthly and has 17% in financials. Only 8% of the Vanguard Dividend Appreciation Fund’s (VIG) holdings are in financials. Now that’s something to appreciate.