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If you are looking for an exchange-traded fund (ETF) that will provide you with dividend income, you can go down one of two broad paths: You can buy an ETF focused on dividends, or you can buy an ETF that focuses on a sector that is focused on dividends. That may sound like doublespeak, but it isn't.
This is why investors with $1,000 or less will want to take a look at Vanguard Real Estate ETF (NYSEMKT: VNQ) today.
A quick look at Vanguard Real Estate ETF
Vanguard Real Estate ETF isn't a particularly exciting exchange-traded fund. As its name implies, it is meant to track the real estate investment trust (REIT) sector in a fairly broad manner. It is pretty cheap to own, with an expense ratio of just 0.12%. And it has a generous dividend yield of 4.3%, which compares very favorably to the yield of the S&P 500 index, which is a scant 1.3% right now.
Real estate investment trusts are specifically designed to pass income on to investors in a tax-efficient manner. So long as a REIT pays out 90% of its taxable income, it doesn't pay corporate-level taxes. The purpose of a REIT is to provide individual investors access to institutional-level rental properties, like office buildings, apartment buildings, and hospitals.
The drawback is that individual investors have to treat the dividends like regular income, which is subject to higher taxes than regular dividend payments. So Vanguard Real Estate ETF is, by design, focused on stocks that are focused on providing investors income -- thus, the relatively high yield.
There's a little wrinkle here, though: Many sector-specific ETFs end up with a couple of stocks that make up a disproportionate share of the fund's assets. Vanguard Real Estate ETF, however, tracks the MSCI US Investable Market Real Estate 25/50 Index, which is specifically designed to enhance portfolio diversification. No more than 25% of the ETF can be invested in any single REIT, and the sum of all REITs with 5% or higher weighting can't make up more than 50% of the ETF's portfolio.
That's a complex way of saying that the ETF is designed so that the biggest holdings won't be shockingly overweighted. For example, Prologis is the largest holding, at around 7.6% of assets, while that same stock makes up 10.3% of the SPDR Dow Jones REIT ETF. If you appreciate diversification, Vanguard Real Estate ETF is designed for you.
Why buy a REIT index today?
Although the dividend yield is the clear attraction for investors here, the bigger picture is that Vanguard Real Estate ETF has lagged the market. As the chart highlights, this ETF fell along with the broader market during the early days of the coronavirus pandemic. But it didn't recover along with the market. That's largely because interest rates rose, which is a general headwind for REITs because it increases operating costs.