What it is:
A dividend ETF is a basket of dividend-paying securities that are bundled together into a single security that can be bought and sold like a stock.
How it works (Example):
A dividend ETF usually mimics part or all of a dividend stock index. For example, the iShares Dow Jones Select Dividend (NYSE: DVY) is an ETF that invests in the 100 stocks contained in the Dow Jones U.S. Select Dividend Index.
Although ETFs hold the same stocks as their underlying indexes, the selection of the index on which to base and benchmark the fund is very important. Even within the dividend-paying universe, there are a variety of indexes. The Dow Jones U.S. Select Dividend Index, for example, selects 100 stocks based on whether and how much the each company has increased its dividends, each stock's trading volume over time, and a variety of other factors.
Some indexes include smaller companies and some focus on larger companies; some stocks also appear in more than one dividend-stock index. Additionally, many dividend-stock indexes include companies from the same industries because certain industries (utilities and financial services, for example) commonly pay dividends.
Why it Matters:
It is especially important for investors to examine a dividend ETF's holdings because the ETF may be purposely or inadvertently using a Dogs of the Dow This strategy is infamous for investing in the highest-yielding dividend stocks without regard to whether the yields are high because of impressive cash flows (good) or falling stock prices (bad). Thus, investors must sure to understand the selection process for a dividend ETF's underlying index.