For investors seeking income, dividend exchange-traded funds (ETFs) have become a popular way to secure a steady source of yield in a portfolio. These days, there are numerous funds with strategies and hundreds of billions of assets under management. The vast bulk of which are considered passive or index ETFs.
However, in recent months, the number of active dividend-focused ETFs has skyrocketed.
With more choices for investors to get their income fix, the question is: could these new active funds be a better dividend choice for your portfolio and income needs?
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The Growth of Dividend ETF Options
One of the best things about ETFs is that they have democratized investing for the masses. The fund structure has allowed a variety of strategies, asset classes and investment options to be quickly adopted by regular Joes. And one of the biggest winners has been dividend-focused investing. According to ETFDB.com, there are more than 100 different dividend-focused funds. The top three largest dividend ETFs – the Vanguard Dividend Appreciation ETF (VIG), Vanguard High Dividend Yield Index ETF (VYM) and iShares Core Dividend Growth ETF (DGRO) – hold more than $130 billion in assets alone. Investors have a wide range of choices these days to get their dividend-income fix.
The good news is the number of actively managed dividend ETFs has continued to grow as well.
Technically, all dividend ETFs fall under the smart-beta umbrella – even the classically styled indexed ones. A human being at some point decides the underlying index’s qualifications, but the number of ETFs in which a manager makes the buy & sell decisions has seen the most growth in recent months. More than 59% (or 197 funds) of all ETF launches in 2021 have been active. According to FactSet, active ETFs took in $83 billion (or 17%) of net flows through to the end of the second quarter. Active dividend ETFs have been a major winner from all those inflows.
Avoiding Losers
The reason why active dividend ETFs have become major stewards of investors’ money could very well be that human touch.
It’s no secret that the pandemic was hard on everyone. In the corporate world, falling revenues, uncertainty and regulatory requirements caused many firms to cut or, even worse, suspend their dividends. This includes some stalwarts of the dividend world like AT&T (T), Boeing (BA), and Ford (F). According to fund manager Janus Henderson, overall global dividends declined by more than 12.2% in 2020, with more than $220 billion in lost payments coming between the second and fourth quarters of year.
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For retired investors or those seeking dividend income, these cuts and suspensions threw them for a loop; especially if they were using broad-based indexed dividend ETFs. One of the problems with indexing is that, in addition to all the winners, you end up holding all the losers as well. While the COVID-19 crisis was a worst-case scenario, many of the ETFs in the theme were caught holding onto firms that either cut or suspended their payouts. And thanks to rebalancing times, investors were as well. This not only increased capital losses and income reductions, but it made for a very volatile ride.
However, this is one area where active dividend ETFs can shine. Managers can focus on cash flows, run disaster scenarios and bet solely on firms they think will be able to keep payments going in times of crisis. Better still, active managers have the ability to instantly sell out of a position and flee to cash if the going gets rough.
Another place where active dividend ETFs are gaining ground on passive index dividend ETFs is in their yields. Typically, the high cost of active management has meant that ETFs often yielded more than their mutual fund counterparts. But with the lower costs of ETFs, active dividend ETFs are now even comparable with their passive rivals. And with costs continuing to fall, investors are gaining more yield.
Finally, active ETFs could be a good bet on the tax front. The issue is, not all passive ETF indices are created the same. Because of this, some tax headaches for investors may be waiting within their ETF. For example, the SPDR Portfolio S&P 500 High Dividend ETF (SPYD) includes REITs in its portfolio mix. Thanks to their tax structure, REITs don’t qualify for the lower dividend tax rate. But active managers can tailor their portfolios accordingly to minimize tax issues and maximize yield. Given some of the tax proposals on the way, this could be an important function of active ETFs going forward.
Active or Passive?
Given that many of the active dividend ETFs are new, it’s hard to gauge whether or not they’ll deliver on their potential to save investors from losses and keep the income flowing. Most of them launched after the COVID-19 crisis was at its worst. The prognosis, however, is still good.
So, what’s an investor to do?
Perhaps, use both. Combining the ease and efficiency of passive dividend ETFs with the potential safety feature of active funds could provide the best portfolio outcome. Risks of income cuts could be diminished, while investors can still enjoy all the benefits of using ETFs. In the end, active dividend ETFs could be a major portfolio advantage going forward. And with costs falling, yields rising and choices growing, investors should consider using them in their portfolios.
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