While it is tempting for income-seekers to chase the highest yield, investors would do better to keep an eye on the long-term. Successful income investing should be a balance between achieving an optimal income stream and protecting the capital over the long term. It is not about chasing short-term performance, but this is what most dividend investors did over the past year.
With technology stocks leading the charge, many investors piled into funds focused on the sector, only to suffer in the sharp sell-off at the end of 2018. Others have focused on attractive but unsustainable headline yields, only to see a number of firms cut their pay outs.
But with the global dividend equity indices yielding more than 4% at present, income investors do not have to take such risks to enjoy a steady stream of income. Dividend-focused exchange-traded funds may not shoot the lights out by backing the Next Big Thing, but they should provide ballast and surety during times of uncertainty.
These are three key reasons why a Dividend ETF may be a good choice for your portfolio:
Capital Preservation
Dividend investing is, at its core, about unsexy necessities. The type of companies in which dividend funds invest in are mostly large and profitable businesses that have been around for a while. A few good examples are Colgate-Palmolive, Johnson & Johnson and Coca-Cola, all of which have reliably paid dividends and, crucially, grown them for the past 55 years.
Apart from consumer staples stocks such as these, dividend ETFs also favour utilities companies, such as water and electricity suppliers, which enjoy a reliable income from a sticky customer base.
With such companies in their portfolios, many dividend ETFs enjoy a steady cash flow and tend to suffer less during times of uncertainty. This is not surprising when you consider the companies they invest in: if the average consumer must choose between their Amazon Prime membership or paying their electricity bill, they will have to opt for the later.
So yes, it is likely that your dividend ETF will miss out on the next Netflix, but it is also likely that most of the companies it holds today will still be around – and paying a dividend – in ten years’ time.
Steady Income
Diversification is a vital component of any successful investment portfolio, and the same is true for an income investor’s portfolio. By holding a range of companies you reduce the impact that any single stock has on your overall returns. Diversification also means you spread the risk of your income stream, ensuring that your dividends come from a variety of sources rather than being overly reliant on one generous payer.
This is particularly important because, as we have seen from the likes of Centrica, Royal Mail and Marks & Spencer in recent months, firms can cut or suspend their pay outs..
Highly diversified ETFs, such as the Vanguard All-World High Dividend Yield, which has been awarded a Morningstar Analyst Rating of Bronze, minimise the negative effect of income cuts by holding nearly 1,500 dividend stocks across 49 countries, ranging from Egypt to the US. The benefits of such diversification have allowed the fund to maintain a steady yield even during major market shocks such as the global financial crisis, eurozone crisis and the Brexit vote.
Another interesting choice is the iShares World Quality Dividend ETF, launched in June 2017, currently holds 339 stocks from developed equity markets including Exxon Mobil and Verizon.
Low Cost
High fees eat into your investment returns and mean less income for you. A growing awareness of the effects of punitive fund charges has led to an increasing appetite for low-cost ETFs in recent years.
Take the following example: You invest £10,000 for retirement income in a fund with an annual ongoing charge of 0.3%. At the same time, you invest £10,000 in a fund that charges 1.65%. You hold both for 30 years, at which point you retire and cash out. For the sake of simplicity, we’ll assume a 10% annual rate of return (gross of all fees) for both funds.
The difference in fees really adds up over time. At the end of the period, the cheaper fund will have grown to £160,000. The more expensive fund will have grown to only £107,000. Assuming 4% dividend yield, the more expensive fund will pay £4,280, while the cheaper fund will deliver £6,400.
