A couple of years ago, I started adding select ETFs and CEFs to my income portfolio. At the time, my thought process was that these funds would diversify my risk and add a degree of stability to my income portfolio. Initially, I had high hopes for their success.  Here’s what I am holding and a synopsis of how they have performed:

Vanguard Financials ETF (VFH)

Vanguard® Financials ETF seeks to track the performance of a benchmark index that measures the investment return of financial stocks.

I first purchased VFH in August 2007. Like the financials it tracks, VFH’s dividend has steadily fell from $0.45/share in October 2007 to $0.06/share in March 2009.

PowerShares International Dividend Achievers Portfolio (PID)

PID seeks to match the performance of the International Dividend Achievers Index by investing at least 90% of its total assets in dividend paying common stocks of this index. This index tracks the performance of dividend paying American Depositary Receipts or ordinary stocks trading on the NYSE, NASDAQ or AMEX.

I initially invested in this fund back in July 2008.  It has paid out three dividends since then, each less than the one before (9/08-$0.14/share, 12/08-$0.09/share and 3/09-$0.03/share). Not a good trend.

Vanguard REIT ETF (VNQ)

Vanguard® REIT ETF seeks to provide a high level of income and moderate long-term capital appreciation by tracking the performance of a benchmark index that measures the performance of publicly traded equity REITs.

I initiated my VNQ position in August 2007.  VNQ’s dividends have been unpredictable and inconsistent.

SPDR S&P Dividend ETF (SDY)

The Fund seeks to replicate as closely as possible, before expenses, the price and yield of the S&P High Yield Dividend Aristocrats Index. The Fund uses a passive management strategy designed to track the price and yield performance of the Dividend Index.

I first purchased SDY in August 2007. I have received seven dividends ranging between a low of $0.4410 (April 2009) to a high of $0.5917 (January 2009). I found it somewhat odd that the low and high dividends both came in 2009.

Vanguard High Dividend Yield ETF (VYM)

Vanguard® High Dividend Yield ETF seeks to track the performance of a benchmark index that measures the investment return of common stocks of companies that are characterized by high dividend yields.

I first bought into VYM in August 2007.  It dividends have slowly drifted lower since that time. They have not been as volatile, but there is no question as to the direction.

Vanguard Dividend Appreciation ETF (VIG)

Vanguard® Dividend Appreciation ETF seeks to track the performance of a benchmark index that measures the investment return of common stocks of companies that have a record of increasing dividends over time.

VIG is another ETF that I first purchased in August 2007. During the time I owned it, VIG’s dividend has flucuated between $0.22/share and $0.28/share.

Eaton Vance Tax-Advantaged Global Dividend Opportunity (ETO)

ETO is a diversified, closed-end management investment company. The Fund’s investment objective is to provide a high level of after-tax total return. It invests primarily in dividend-paying common and preferred stocks.

I first purchased ETO in July 2008. ETO paid a steady dividend of $0.1795/share through December 2008. It then dropped its dividend to $0.1167/share.

Alpine Total Dynamic Dividend Fund (AOD)

AOD attempts to optimize both dividend income and long-term growth of capital. This is a very diverse and flexible fund. It employs a global, multi-cap, multi-sector, and multi-style investment approach. The fund combines four research-driven investment strategies – Growth, Value, Special Dividends, and Dividend Capture Rotation.

I first purchased AOD in December 2007. It paid monthly dividends of $0.18/share through February 2009 before cutting its monthly dividend to $0.12/share.

Vanguard Long-Term Bond ETF (BLV)

The Fund seeks to match the investment performance of the Lehman Brothers Mutual Fund Long Government/Corporate Index. Holdings include Corporate Notes/Bond 51.5%, Treasury Notes/Bonds 40.2% and Government Agency Securities 6.5%.

I first purchased BLV in December 2008. Since that time I have received five dividend all approximately $0.34/share. This has been the one bright spot amoung the group. As a long-bond fund, it has behaved as I expected it would.

Conclusion

Back to the original question: Are Exchange Traded Funds (ETFs) and Closed Ended Funds (CEFs) a good fit for this dividend investing? At this point, I would say no, for the most part. For many of the same reasons that international investments are not a good fit for a dividend-based investing strategy, I have found the same true with ETFs and CEFs.

It has been my experience that ETFs/CEFs dividends exhibit a higher degree of volatility than individual dividend stocks. Since most of the above funds are based on an index, they are forced to buy the bad stocks with the good stocks. This will inherently increase the volatility of the funds dividend payments. Those with international holdings are subject to currency conversion and a different dividend payout philosophy. In the income portion of my portfolio, I place a great deal of value on stability and consistency. ETFs and CEFs have a difficult time delivering either.

The funds are listed is ascending order from least desirable to most. I have already stopped purchasing the above funds, except BLV.  I will now work on eliminating or minimizing my position in most of them, starting at the top of the list and working down.

Full Disclosure: Long VFH, PID, VNQ,  SDY, VIG, VYM, ETO, AOD, BLV.  See a list of all my income holdings here.

Before 2008 when the U.S. Securities and Exchange Commission authorized the creation of actively-managed ETFs, all U.S. ETFs tracked an index. It is not surprising that the older ETFs track the most popular indexes such as:

• S&P 500 Depositary Receipt (SPY) tracks the S&P 500 Index
• Vanguard Total Stock Market ETF (VTI) tracked Dow Jones Wilshire 5000 Composite Index through April 22, 2005, and performance of the MSCI US Broad Market Index thereafter.

Given the efficiencies of ETFs there has been a great deal of interest in them.  Despite 2008′s market crash, there were 160 new exchange-traded funds launched with net inflows into U.S. equity exchange-traded funds of $120.8 billion.  ETFs are gaining market share at the expense of mutual funds. In 2008, there were only 21 new mutual funds and U.S. equity mutual funds saw a $162.4 billion net outflow. Many mutual fund companies have seen the writing on the wall and have decided that if you can’t beat them, join them.

At the time of this writing, Vanguard offerd 38 ETFs covering just about every conceivable sector and niche. Here are several random samples:

• Long-Term Bond ETF (BLV) tracks  Lehman Brothers Mutual Fund Long Government/Corporate Index
• Dividend Appreciation ETF (VIG) tracks the Dividend Achievers Select Index
• REIT ETF (VNQ) tracks Morgan Stanley REIT Index
• FTSE All World ex US (VEU) tracks the FTSE/(R)/ All-World ex USA Index

ETFs can be used to fill a void where you either don’t have the expertise or the time needed to pick individual stocks, such as international dividend investing. Like any other index, an ETF will likely hold securities that you would not buy otherwise.

Full Disclosure: Long VTI, BLV, VIG, VNQ

References
- Forbes: Attack Of The ETFs
- Wikipedia: Exchange-traded fund
- SEC: Exchange-Traded Funds (ETFs)