Dividend ETFs have surged in popularity in the past decade. With most segments of the bond market providing unattractively low yields, investors have gravitated to dividend ETFs to make up for some of the lost income.

This approach has worked very well in recent years. Not only do many dividend ETFs provide yields well in excess of investment-grade bonds, but they have also enabled investors to participate in the roaring bull market that has been in effect since March, 2009.


Not least, a raft of studies – some of which are cited here – has made investors well aware that while dividend stocks sometimes lag in the short-term, they tend to outperform the broader equity market over time.

Despite all of this, investors need to take care not to fall asleep at the switch. With stocks having performed so well in the past five-plus years, it’s easy to forget that all forms of equity investments are a higher-risk proposition than bonds. Notably, this statement remains true even if rising interest rates begin to take a toll on bond-market performance in the years ahead.

It’s even more important to keep in mind that even though dividend ETFs tend to have lower risk than the market as a whole, they still have substantial risk on an absolute basis.

This seems to be an issue that even the experts sometimes overlook. Almost every day, the financial media is flooded with stories that have attention-grabbing headlines such as “5 Crash-Proof Dividend Stocks!” and the like. This may sound good on paper, but there simply isn't any such thing.

Dividend stocks, and high-dividend ETFs, are as vulnerable to falling markets as any other types of equity investment.

In 2008, for instance, the S&P 500 Index of large-cap U.S. stocks fell 37%. In that same year, one of the largest dividend ETFs, iShares Select Dividend ETF (DVY) comfortably outperformed the broader market. However, it still lost 32.9% on an absolute basis. Clearly, the “protection” afforded by dividend stocks was only a factor in relative – and not absolute – performance.

This is particularly important to keep in mind when it comes to dividend ETFs that focus on higher-risk segments of the market, such as mid-cap stocks (MidCap Dividend Fund, DON) and small caps (SmallCap Dividend Fund, DES). Again, the fact that these funds have the word “dividend” in their name doesn’t mean that they’re low-risk. Mid- and small-cap fund will have the same risk as plain-vanilla funds invested in these asset classes, with maybe a few points’ worth of better relative performance in weak markets.

This consideration is especially acute when it comes to dividend ETFs that invest in the emerging markets in general, and small-cap emerging markets stocks in particular. In 2011, for instance, WisdomTree Emerging Markets SmallCap Dividend Fund (DGS) fell 21.2%, worse than most large-cap emerging markets funds performed in the same year. The fund has delivered robust longer-term performance, and it’s certainly worth considering for investors who can buy and hold for ten years, and who can weather the impact of short-term market volatility. Still, it's clear from the events of 2011 that the fund is highly vulnerable to market downturns despite its emphasis on dividend stocks.

The Bottom Line

Dividend ETFs certainly can play a role for a wide range of investors. They offer above-average income, below-average volatility versus the broader market, and – for those who reinvest the income – a good starting point for generating longer-term total return. In addition, the income component of dividend funds provides investors with a way to offset the destructive impact of inflation over time. Just be sure you understand exactly what you’re getting – and don’t expect to make it out of a stock market downturn unscathed.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.