Over the past decade income-seeking investors have poured money into dividend-screened UK equity ETFs. Their appeal continues to be supported by the ultra-loose monetary policy and historically low bond yields.
Investors have several passive options to choose from. This diversity can make choosing the right fund a daunting task; not least when confronted with very different investment strategies marketed under a similar message.
Why Dividends?
Equity dividends have a tendency to rise over time, and so potentially they offer income-seeking investors better long-term inflation protection than conventional bonds.
That said, not all dividend-paying companies behave equally. Some are mature, slow-growth firms with strong cash flows and a conservative, albeit stable, approach to dividend pay-outs. Their stocks tend to react more in line with bonds to fluctuations in interest rates. Others are growth-oriented companies, usually with more aggressive expansion plans; firms that tend to mark their success by raising dividends, but are also more prone to volatility.
The ETF Advantage
Dividend-weighted ETFs offer an efficient solution to investors. Not only do they cover the heavy lifting of researching and selecting the right stocks, but they also benefit from the usual positives of using ETFs, including transparency of the strategy and the fund’s holdings.
Unlike holding a handful of individual stocks, buying a well-diversified ETF can protect investors from over-exposure to a single firm or sector. For example, an equally-weighted portfolio of 10 stocks can deliver a significant loss even if just one or two stocks experience a severe price decline. Dividend-oriented equity ETFs usually hold at least 30 stocks, and so winners more easily help offset losers.
Finally, the cost advantage of ETFs form a formidable hurdle for active managers hoping to generate value over the long-term. In the case of yield-focused equity strategies, two of the most popular ETFs, iShares UK Dividend (IUKD) and SPDR UK Dividend Aristocrats (UKDV) charge 0.4% and 0.3%, respectively. This compares to 0.95% charged on average by actively-managed peers.
High-Yielding Not Be the Best Option
The basic merits of the ETF wrapper are universal, but investors should not be fooled into believing that all ETFs offering exposure to a given market or strategy do so in the same manner. This is particularly so when moving away from plain vanilla market-cap-weighted exposures; such is the case of dividend-screened equity strategies.
Some of these ETFs focus on squeezing out the highest possible pay-out, while others concentrate on assembling higher-quality companies that aim to maintain a balance between income and long-term capital growth.
For an income-seeker the iShares UK Dividend ETF, which currently sports a dividend yield of 5.03%, might initially appear an attractive choice. Its portfolio is made up of the 50 highest-yielding UK stocks. However, the index that this ETF tracks simply ranks stocks by promised yield. No measures are taken to evaluate the companies’ debt levels or to ensure that they are likely to remain profitable.
This exposes investors to the danger of dividend traps. In this scenario, a company may be promising a dividend that it cannot afford. For example, during the financial crisis in 2008, this ETF suffered significantly from holding stock in European banks that went on to suspend planned high dividend pay-outs.
The absence of sustainability screening is the key reason why Morningstar awards a Negative Analyst Rating to this ETF.
By contrast, the SPDR UK Dividend Aristocrats ETF tracks an index that holds 30 companies that have consistently raised or maintained dividend payouts over a period of 10 or more consecutive years. In practical terms, these are companies for which a stable dividend distribution policy trumps the promise of a high payout.
Our analysis showed that the companies in this portfolio have better profitability characteristics and lower debt. But consistency usually comes at the expense of a lower yield, which for this SPDR ETF stands at 3.97%. Nevertheless, in our view, this is a superior investment strategy.
When it comes to passive funds, it pays not to overlook that the strategy is defined by the index. Hence, thorough due diligence on benchmarks must be a key criterion in the fund selection process.
