The Best Income Index You’ve Never Heard of

I’d bet that most Investor Update readers know about the S&P Dividend Aristocrats Index.

To be included in this index, an S&P 500 company must have raised its dividend annually for at least the past 25 years. The standard is brutal: One slip and you’re out. Start all over and compile another spotless dividend track record over the next 25 years.

This is an index of the bluest of blue-chip dividend stocks. But I’ve found a little-known “sister” index that income investors might find even more interesting…

Strong Appeal for Income Investors
How can you improve on an index that contains some of the best dividend-payers in history? The S&P’s High Yield Dividend Aristocrats Index has just the answer.

This index holds companies to the same lofty standard of at least 25 consecutive years of dividend increases. But it selects companies from the S&P 1500, which includes mid-sized and small-cap companies. That means the High Yield Dividend Aristocrats are put together in such a way as to balance both growth and income, as opposed to the Dividend Aristocrats Index, which is focused mainly on income generation.

#-ad_banner-#The two indices have other important differences as well. For starters, the plain Dividend Aristocrats Index is constructed of a shifting number of stocks, all of which have an equal weighting.

In contrast, the high-yield version is built around a fixed number of companies — 50 of them, to be exact. Instead of being equally weighted, each company is weighted according to its dividend yield. The companies with the highest yields exert the most influence on the index’s performance.

To prevent a handful of stocks from having too much influence, no one stock can have more than a 4% weight in the portfolio. Additional criteria for inclusion are that the stock must have a market capitalization of at least $500 million dollars and trade a minimum of 1.5 million shares in a calendar month.

And since the High Yield Dividend Aristocrats Index includes stocks from any of 10 economic sectors, it offers more diversification than many high-yield indices, which focus only on securities from traditional income sectors such as financials and utilities. As of June 30th, four sectors made up more than two-thirds of the High Yield Aristocrats. The leading sector was financials (23%), followed by utilities (16%), industrials (15%) and consumer discretionary (14%). Not a single energy stock, although the group makes up more than 13% of the S&P, made the cut for the index.

The High Yield Aristocrats are no slouches when it comes to returns either. An S&P study showed that the index outperformed the S&P 500 for a decade in virtually all types of market conditions. For the 10 years ended June 30, 2009, the index beat the S&P by nearly five percentage points. For the last five years, the results have been similar.

It is in bear markets, however, that the role of dividends in cushioning stock price declines is most important. In 2008, the S&P 500 declined -37%, but the High Yield Dividend Aristocrats Index was off by just -23% — a roughly 1,400 basis point improvement.

And in the March to June 2009 quarter, which saw a sharp rally off a bear market bottom, the index performed virtually on par with the S&P 500. Both gained nearly +16% for the period.

In a variety of market conditions, this little-known index has been able to match — and usually beat — the broader markets, while also paying a higher yield.

Given the relative strength of the High Yield Aristocrats, owning a share of royalty may not be a bad idea. The easiest way to invest is to buy the exchange-traded fund (ETF) designed to mirror its performance, the SPDR S&P Dividend (NYSE: SDY). During the past four quarters, SDY paid $1.88 per share, so it’s yielding about 4.5% at the current prices.

But if you’re looking for even higher yields, you might try some of the individual stocks contained within the actual index.

P.S. — In my November issue of High-Yield Investing I took a peek inside the High Yield Dividend Aristocrats Index. In particular, I highlighted one stock that is yielding 6.2%, but the best part is that this company is poised to grow earnings +69% in 2010. To learn more, please visit this link.