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As investors scramble for income, these are the best dividend ETFs, according to Morningstar

Key Points
  • Investors need to understand the risks when buying dividend-focused funds, experts warn.
  • To find the best dividend funds, Morningstar looks through expense ratios, how the funds weigh certain stocks as well as technical factors such as tracking errors.
  • Vanguard High Dividend Yield ETF is one of the highly rated ETFs, which offers a dividend of 3.12%.
  • Safer dividend strategies have a screen for profitability or quality.
Traders on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters

As bond yields plunge to historic lows, investors craving for steady income are turning to dividend-focused funds. But beware — not all dividend exchange-traded funds are created equal.

There are hundreds of ETFs that currently offer much higher payouts than the benchmark 10-year Treasury, whose yield has tumbled to only around 1.5% during this historic move globally lower in rates.

However, investors need to understand the risks when buying these funds, experts warned.

"I think what a lot of people overlook is they get too caught up in just searching for yields," Daniel Sotiroff, a manager research analyst for Morningstar. "Some of the funds don't have effective screens that look at profitability and stability of the business...Some have distressed companies in the high-yield market. You have to know what you are getting into."

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Companies with big dividends tend to have lower growth potential and some of them have difficulty in sustaining their dividend payments, whereas dividend growers usually have a lower yield but safer payouts. Some income-oriented funds on the market seek to find a middle ground between the two types of stocks.

These five ETFs are highly rated by Morningstar analysts, who looked through expense ratios, how the funds weigh certain stocks as well as technical factors such as tracking errors. Vanguard High Dividend Yield ETF offers the highest dividend of 3.12% among the five ETFs (The dividend yield for the S&P 500 is about 1.85%).

"It's a forward-looking assessment," Sotiroff said. "If you are a medalist, we are pretty confident you are going to outperform the category median in the long run over a full market cycle."

The funds all have a screen for profitability or quality, which means they are more able to continue paying dividend. Some of them also weigh the constituent stocks in a more sound fashion than some other funds reaching for yield.

"It's going to tilt the portfolio toward the larger companies that are more likely to be profitable and stable. it's also going to reduce the unnecessary turnover in the portfolio," Sotiroff said.

The top holdings of these funds include familiar names including AT&T, Exxon Mobil, Verizon Communications, Intel which currently pay dividend around 4% and 5%.

Low interest rates are here to stay as the Federal Reserve is expected to continue cutting this year to combat an economic slowdown. Former Fed Chairman Alan Greenspan said it's "only a matter of time" before negative rates spread to the U.S.