Bank on bigger dividends in this sector next year

Yield-hungry investors take note. A former dividend darling is back: the banks. And you can capture the return of the dividend king with some big, inexpensive ETFs.

The financial services sector is expected to be the dividend growth leader among sectors next year, according to the FactSet Dividend Quarterly.

While FactSet expects all 10 S&P 500 sub-sectors to report dividend growth next year, only financials (14.8 percent) and consumer discretionary (10.3 percent) sectors are expected to report double-digit growth in dividends.

The long tail of the financial crisis is poised to help bank stocks from a dividend investor perspective: it results in higher dividend-growth expectations. Six years into the comeback from the Great Recession and many Fed stress tests later, Bank of America and Citigroup—whose dividends lagged behind other big banks—are finally getting back on track. Bank of America boosted its dividend 400 percent this year and more increases for both banks are coming, the FactSet report stated.

Meanwhile, JPMorgan and Wells Fargo have been dishing out hefty dividend hikes since 2011.

More dividend increases are coming the further away banks move from the post-financial crisis cuts. And the combination of bank dividend stalwarts and comeback banks makes financial services ETFs a good bet, said Neena Mishra, director of ETF research for Zacks Investment Research. It's a dividend trend also supported by the broader economic growth story in the U.S. "When the economy picks up, that's good for big banks," Mishra said.

Financial services companies also historically do well in times of rising interest rates, said Jeremy Office, a principal at Maclendon Wealth Management, and many market pundits are predicting the higher rates will finally arrive in 2015, in line with commentary from the Federal Reserve.

Though Mishra added a note of caution: small banks, whose revenue is more dependent on loans, aren't doing as well. Year to date, the large-cap KBW bank index is up 10.8 percent. The KBW regional banking index, meanwhile, is only up 3.75 percent this year.

Where best to seek bank dividends in big, liquid ETFs?

With more than $21 billion in assets, SPDR Financial Select Sector ETF (XLF) is one of Office's top picks. It has nearly 50 percent of its holdings invested in the biggest banks including Wells Fargo and Bank of America. The ETF yielded 1.59 percent over the past 12 months.

But the ETF goes beyond just the banks. "SPDR Financial Sector ETF has diversified holdings, and it also has a cheap expense ratio at 0.16 percent," Mishra said. "It's a good place to look for rising dividends." XLF has 85 holdings, including insurers and real estate investment trusts.

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Vanguard Financials Index ETF (VFH) is another inexpensive way to fish for banking dividends. Its expense ratio is 0.12 percent—it was among the Vanguard sector ETFs to benefit from the fund giant's decision last week to cut expenses on some sector ETFs as the price war continues among ETF providers.

Wells Fargo, JPMorgan and Bank of America are its top three holdings, though VFH holds many more financial stocks than XLF, with 543 holdings. It has yielded 1.84 percent over the trailing 12 months, and Office said the yield combined with the broad diversification make it a good option.

Both big ETFs have another lure: solid total returns that combine performance with yield. Year to date through Dec. 29, VFH is up 15.5 percent. In the past one-year period through Nov. 30, XLF returned 15.4 percent and VFH returned 14 percent.

Both XLF and VFH offer solid dividends, but bear in mind, the S&P 500 had a higher dividend yield over the trailing 12 months, through Dec. 29, at 1.9 percent. That's not a surprise: the financials sector is currently the only sector with trailing 12-month dividends below its 10-year average. It also means to get the highest yields from financials, investors must take on more risk.

When sorting through the financials, it would be a mistake to blindly chase yields. "Don't get fancy and let the yield wag the dog," Office said.

Consider PowerShares KBW High Dividend Yield Financial Portfolio (KBWD). It has yielded a hefty 8.2 percent over the past 12 months, but the ETF is flat this year.

One reason: KBWD's 40 holdings include lots of small banks, along with mortgage real estate investment trusts. "There are inherent risks in the ETF," said Robert Goldsborough, an ETF analyst at Morningstar. "And it hasn't been around very long," he said. KBWD launched in 2010, so it has not been through a financial crisis.

The expense ratio on KBWD is also very high—even compared with actively managed mutual funds—at 1.55 percent.

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Looking beyond the U.S. for financial service plays has its risks too. The iShares MSCI Europe Financials Sector ETF (EUFN) racked up an enticing 3 percent yield over the past 12 months. But it is down 2 percent year to date. "You must have a strong stomach to invest in European financial services," Goldsborough said.

Mishra thinks that European financial services may benefit from quantitative easing measures, and it's a trade that is stabilizing. Her only concern is that EUFN doesn't have a hedged currency structure, and so can be roiled by what has been a very strong U.S. dollar, which is expected to remain strong in 2015.