Dividend-Focused ETFs Are Taking Off

It's no coincidence the ETF can trace its roots back to the summer of 2003. It was four years ago this month that President Bush, standing behind a podium in the East Room of the White House, touted a new piece of legislation called the Jobs and Growth Tax Relief Reconciliation Act that, among other things, slashed the tax rate on qualified dividends to 15% from as much as 38.6%. While Bush spoke highly of its positive impact on baby boomers' wallets, he also surmised it would bring to a close the memories of the tech bust. "The days when people could say, 'Invest with me because the sky's the limit,' will be changed by dividend policy," he said. "It's hard to...pay dividends unless you are actually profitable."

He's right, of course, because you can't fudge a dividend payment. But Bush might have been too optimistic about putting an end to pie-in-the-sky corporate shenanigans. However, the legislation has been a boon to dividend-focused products. While mutual-fund firms have embraced this trend — according to Lipper, equity income funds, which typically buy dividend-paying stocks, have doubled in number to 267 since 2002 — so has the exchange-traded-fund world. WisdomTree, PowerShares, State Street and Vanguard each have dividend-focused products.

Further spurring this trend is the change of heart about dividends not only from individual investors but inside many boardrooms, too. Baby boomers, especially those burned during the late 1990s downturn, have flocked toward dividend-focused ETFs. Wisdom Tree has amassed almost $4 billion in assets after just a year on the market. The iShares ETF has a whopping $8.7 billion sitting in its coffers. These inflows mirror similar flows into equity-income mutual funds, which have seen their assets balloon 150% to $166 billion since 2002.

In addition, according to Standard & Poor's, 383 companies in the S&P 500 index now pay dividends, up from 351 in 2001. Most of those are financial firms, like banks, but tech companies such as Microsoft (MSFT) are some of the newer names that have paid out cash to shareholders. The payout ratio — the percentage of earnings paid to stockholders in dividends — is currently 32%, well below the historical average around 50%. But our experts think that mark will increase, especially if the legislation is renewed some time after 2010. "Share buybacks don't indicate how a board of directors feels about the future of a company," says Judy Saryan, an Eaton Vance vice president and portfolio manager. "Investors have become more conservative. They want a strategy with lower risk."