Finally a free lunch! Or maybe not.

Written by John Osbon on December 12, 2012

When one basket of stocks pays a 2 percent dividend yield, and another, seemingly very similar one pays 6 percent, which one do you want to own? In today’s one percent bond yield world, it’s not a hypothetical question. Two popular ETFs, both comprised of some of the world’s best known companies, present this puzzle. Let’s sort it out.

SPY is State Street’s S&P 500 index ETF and VGK is Vanguard’s European index ETF.  Both hold hundreds of stocks and have razor thin management costs: 9 basis points for SPY and 14 for VGK.  Almost nothing.

The stocks they contain are literally household names – the biggest US- and European-based companies, true global competitors.  You can be sure that Exxon Mobil and BP are always squaring off for the best oil and gas deals, and that Pfizer and Sanofi and Roche are doing the same in pharmaceuticals.

Major holdings of SPY and VGK.

With similar contents, the dividend yields seem to be from completely different planets. SPY yields 2.01 percent as of this writing and VGK 6.33 percent (source: Yahoo Finance).

Look closer

All other things being equal, that 6 percent yield makes VGK much more desirable. But other things are rarely equal, and they’re definitely not in this case.

The obvious difference is geography. With VGK holdings all based in Europe, they are more susceptible to the uncertain future of the euro and any real or rumored national defaults. Further, the results for any US investor buying VGK will be filtered through ever-changing exchange rates for the dollar versus the pound, euro, and Swiss franc. (See “Ignore currencies at your peril”)

The companies in VGK also face different political environments, toil in different central bank territories, and pay different tax rates than their US counterparts.

Six percent, but at what cost?

So the big dividend gap…does it make sense?  We can’t answer that, but we can tell you that VGK is up 7.75 percent over the last 12 months. SPY is up 22.6 percent (source: Google Finance). Maybe European companies are selling at some kind of a “fear discount” that investors demand for stomaching the extra uncertainty hanging over Europe these days. Viewed another way, the big yield may be a “fear premium,” a reward for the extra risk.

Our point is not to anoint one of these ETFs the winner. We just want to draw attention to the many other things not being equal in any comparison of different securities. Before you leap for something you like, such as a big yield, make sure you understand there are other variables that come with the package.

As for that free lunch? We’re still on the lookout.


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