Avoid the Dividend Trap

Dividend-paying stocks are often seen as being higher-quality and more stable than their non-dividend-paying stock counterparts. Thus, they can be viewed as the next step up on the risk/return spectrum from lower-risk bonds to higher-risk stocks. But there is a point at which dividend-paying stocks actually become more risky than the average stock. Earlier this summer, shares of BP offered a trailing 12-month dividend yield of 9%. But the market was correctly forecasting that this dividend would be cut. Another example is New Century Financial, a subprime mortgage REIT that offered a dividend yield of around 18% at the peak of the housing bubble. That dividend did not last long, as the firm filed for bankruptcy when the bubble burst. In this article, we take a look at the ways that dividend-focused exchange-traded funds look to avoid this siren song.

Dividends have historically accounted for 40% of the returns from investing in stocks, and despite conventional wisdom, high-dividend-payout companies tend to have stronger earnings growth. So, the case for investing in companies that pay dividends is a strong one. It would seem that a logical way to achieve a high yield on a dividend fund would be to weight stocks by their dividend yield, so that high-yielding stocks would make up a larger percentage of the fund. But unfortunately, it is not correct that if dividends are good, a higher dividend yield must be better. The fact is that neither of these approaches would do anything to screen out the low-quality, risky companies that are likely to cut their dividends, or even file for bankruptcy.

Source: Morningstar

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