Buying Exchange Traded Funds

By Bob Moeller
WEAC Member Benefits

May 2005

Financial Planning Seminars
Achieving Financial Independence

One of the fastest-growing areas in investments involves Exchange Traded Funds, or ETFs. These are simply mutual funds set up to hold only certain stocks, and shares of the fund itself trade on a stock exchange. Thus you can trade them like stocks, and since they are limited in their holdings management, expenses are very low. The best known ETF might be the S&P 500 Fund ETF, which consists of stocks of the largest 500 companies in the weight they exist in the stock exchange. The symbol is SPY, and you buy it just like a share of stock in an individual company.

Recently a couple of ETFs have been created for the sole purpose of holding stocks that pay dividends in increasing amounts each year. They are something that any investor should consider. The two I am familiar with are the I-Shares Dividend ETF (symbol DVY) and the PowerShares High Yield Equity Dividend Achievers (symbol PEY).

I already owned some DVY when the PEY issue came out in December 2004. I thank Larry, one of our members, for alerting me to the PEY issue, which I now also own.

So what’s the deal? First, good dividend-paying issues are paying more than you can earn in short-term interest accounts. Second, good dividend companies will tend to raise their pay-out each year, so your income will keep up with and/or exceed inflation increases. Third, the maximum federal income tax rate on dividend income is 15%, well below the marginal 25% rate many members are paying. Finally, these issues are easy to buy, easy to hold, and have low annual fees.

A quick look at each:

PEY: The fund holds 50 stocks. These stocks are the 50 highest-yielding companies with at least 10 years of consecutive dividend increases. I see this fund as taking a lot of work out of figuring out which dividend issues to buy. The maximum annual fee is 0.5%. The current yield is 4.1% less the 0.5% fee, or 3.6%. Examples of stocks held are Genuine Parts, yielding 3.1%, (47 consecutive years of increased dividends); MGE energy (Madison Gas & Electric to us bill payers), yielding 4.3% with 28 consecutive years of increases. A total of 40% of stocks are utilities, 40% financials (mostly banks), 27% large cap value, 29% mid cap value, 26% small cap value. Negatives? Eventually competition will probably result in new ETFs with lower annual fees, but until then, this is a good way to involve yourself in the stock market. Also, if interest rates rise substantially, the dividend yield may not rise as fast and these funds may lose some of their attractiveness in the short term. The Web address is www.powershares.com.

DVY: This fund holds 30 stocks. These stocks correspond generally to the Dow Jones Select Dividend Index. Expense fee is 0.4%, and current SEC yield is 3.25%. Examples of stocks held are Bank of America, yielding 3.53%, and DTE Energy (Detroit Edison), yielding 2.64%. DVY has 35% in banks, 14% in electricity, 9% in chemicals, and other lesser groups. Negatives? Same as PEY. The Web address is www.ishares.com.

In summary, what might this kind of investment do for you? Probably pay you a return that grows each year. The value of your investment over time will grow as will most stock investments, but with less volatility and risk. You can sell anytime you like, of course, and pay just regular commissions to sell. There are no withdrawal penalties.

The best way to buy these issues is through a discount broker. Expect to pay in the area of $20 or less for each order to buy or sell, no matter how many shares you buy or sell if you do business with a good discount broker and do your own trading over the Internet. Possible sources are Waterhouse at Siebert

1-800-872-0711, Fidelity 1-800-544-8544, E-Trade 1-800-387-2331 and
Scottrade 1-800-619-7283.

You want reasonable rates to buy or sell, such as less then $20 per trade, and you want assurances that if your account is inactive for a period of time you will not be charged inactivity fees. In general, look over all the costs and select based on your individual needs. If you have a sizable account, many of the fees are waived, so find out what that account level is. You may access my March 2004 article about using discount brokers on OnWEAC.

Because of the commissions involved in buying these shares, you do not want to involve yourself if you are only in a position to buy a few hundred dollars worth. A $20 commission is 1% of a $2,000 trade, which is a reasonable percentage. Of course, it is only ½% of a $4,000 trade, and that’s even better. Commissions, fees and other costs are important to consider in all of your investing.

Posted May 11, 2005