While soaring share prices steal all the headlines, dividends are a major driver of the returns from equity ownership. From 1987 to 2010, just over one-third of the difference between the total returns of the EURO STOXX 50 and the price returns can be attributed to reinvested dividends. Dividends put cash directly in your pocket, and tend to provide a much more stable source of total returns than price appreciation, which depends on the vagaries of the latest market movements. Today looks like a good time to move back toward dividend-paying stocks as well, since painful dividend cuts are historically very rare and 2008 saw payouts cut more deeply than any other year in recent decades. With the worst of the credit crisis now in the rearview mirror, most current payouts appear sustainable. Considering the low yields available on bonds today, now may be a good time to pick up an ETF of blue-chip European companies yielding 3-4% on average.
Dividend shoppers can be easily fooled by shares sporting the very highest dividend yields. Whilst at first glance these payouts might look attractive, a lofty yield often serves as a warning sign that the market views a firm’s payout level as unsustainable. Dividend-focussed ETFs are passive instruments and may not be able to drop companies whose dividend is in peril. For example, at year-end 2008 the FTSE UK Dividend Plus included substantial positions in Electrocomponents and Tomkins because of their high yield, which unfortunately foreshadowed their dividend cuts in 2009. However, the diversification offered by a dividend-focussed ETF serves to mitigate the potential ill effects of a dividend cut by any of its individual holdings.
The Dividend Index Line-up
There are a number of dividend-focussed indices that are tracked by ETFs. It's important to note that many of these indices may look similar on the surface, but closer scrutiny of their actual composition can turn up important differences. For instance, the MSCI Europe High Dividend Yield index has nearly 50% of its assets in shares of British firms, while the STOXX Select Dividend 30 index has an 11% slice of UK equities. It is also important to scrutinise these funds’ degree of industry concentration. It is often the case that if one company in a given sector runs into trouble and has to cut its dividend, its peers may not be far behind. For instance, three large UK financial companies, Lloyds Banking Group, Royal Bank of Scotland and Barclays, all slashed their dividends within months of each other in the autumn of 2008.
Market-Capitalisation Versus Fundamental Indexing
The majority of equity indices are market-capitalisation weighted—the larger the components’ market capitalisation, the larger its weighting in the index and vice versa. Meanwhile, most of these dividend-focussed indices use fundamental indexing techniques to select and weight their components. Fundamental indices choose their components based on certain criteria, often accounting metrics like earnings and book value. In this case, because they are dividend indices, the stocks are selected and weighted based on their one-year forecasted dividend yield, often with limits on concentration and turnover.
There continues to be a debate surrounding the merits of fundamental indexing, with the case being made that fundamental indices have historically outperformed only due to their value and small-capitalisation biases. In this case, because of their preference for high dividend yielding stocks, dividend ETFs will always tend to have a value tilt. However, weighting by market capitalisation avoids the small-cap bias inherent in many fundamental indices.
A Look at the ETF Menu
Here's a menu of the various dividend-focussed ETFs currently available.
The iShares EURO STOXX Select Dividend 30 ETF is the largest dividend themed ETF as measured by assets under management, and it is also one of the most liquid in terms of average trading volume. With regard to expenses, there is one clear winner: the iShares STOXX Global Select Dividend 100 ETF. The fund's 0.17% total expense ratio is little more than half the level of the next cheapest fund. The Europe-wide and EMU ETFs have both physical replication (iShares and Lyxor STOXX Select Dividend 30 and iShares and ETFLab EURO STOXX Select Dividend 30) and swap-based options (Amundi MSCI Europe & EMU High Dividend and Source EURO STOXX Select Dividend 30), so investors have plenty of options. Income-seeking investors may prefer the distributing funds (which distribute dividends to fund holders) over capitalising funds (which reinvest dividends). It is essential to keep tax considerations in mind when choosing between these two.
Finally, if you're hunting for yield, don't limit your search strictly to the field of dividend-focussed ETFs we’ve treated here, as there are other options available. For instance, utilities generally sport fairly attractive dividend yields, so an ETF tracking the utilities sector might also be a good bet for income-oriented investors. Your personal tax considerations also have a role to play. But like in all investing decisions, the final consideration should be safety of principal. Be very cautious about yields that look like they might be unsustainably high. There are two ways the yield can come down, dividend cuts or principal reductions, and neither of them are particularly pleasant for investors.
One final caveat: Many of these dividend indices, particularly the UK and pan-European indices, devote a big chunk of their weighting towards BP. The yield on the shares has increased since the Deepwater Horizon accident in the Gulf of Mexico as the share price has been hammered, but BP management yesterday announced the cancellation of the first quarter dividend, which had been due to be paid on June 21, and said not interim dividends will be declared in the second or third quarters of 2010. BP reiterated its commitment to paying future dividend and said it would resume payments in 2011, by which time it expects to have a clearer picture on the long-term impacts of the oil spill. Until there is more clarity on the situation, investors may want to steer clear of dividend ETFs that include BP, such as the Amundi MSCI Europe High Dividend and the iShares FTSE UK Dividend+.
