Don’t rely on ETFs for steady income

We were contacted by one Investors Chronicle reader, who said he bought iShares's Emerging Markets Dividend UCITS ETF (SEDY) after cherry-picking it from John Baron's portfolio. At the time, the yield it offered was over 7 per cent, but after it fell to just 3.55 per cent, our reader decided to ditch it, along with db x-trackers Global Dividend Stoxx Global Select Dividend (XGSD), from his portfolio. To replace these two funds, he bought Murray International (MYI), a global growth and income investment trust and member of the IC Top 100 Funds, which he says provides smoother returns. He said: "I felt constantly unsure about what was happening to my dividends. At least with an investment trust you can go along to the annual general meeting and cause a rumpus if the dividend has been cut, but you can't do that with an ETF (or a unit trust) and no one explains what is going on!"

Why equity ETF dividend payments can be erratic

If you buy a physical equity ETF you should not expect dividends to be smooth. This is because dividends paid by the underlying companies are seasonal, and this can impact the dividends paid by the ETF. Synthetic ETFs, on the other hand, don't have these problems, because their investments are swap-based, which means the dividends they pay out aren't actually coming from physical companies.

Physical ETFs which pay quarterly are much more likely to have fluctuating dividend payments than those that pay out every six months or annually, says Gordon Rose, an ETF analyst at Morningstar. This is because companies tend to pay small interim dividends and large final dividends, generally around May or June once they have ruled off their year-end, had their audit, approved their accounts and had the shareholders approve the dividend at the AGM. This means you can expect to get large dividends in May and August, and smaller dividends in November and February.

But this isn't a reason not to buy ETFs that pay a quarterly dividend, according to Mr Rose. "There's a fine balance between smoothing dividend payments by spreading them out, and spreading them out so far that market timing issues could cause severe tracking error, meaning the ETF would fail to do a good job at closely tracking its index."

A quick look at the iShares FTSE 100 UCITS ETF Inc (ISF) shows there is a seasonality to the dividend payouts. Peter Sleep, a senior portfolio manager at Seven Investment Management, says: "ETF dividends precisely reflect what is going on in the underlying market. Income dividend ETFs will have a policy of paying out all the dividends they receive, and dividend cuts will be directly reflected in the ETF. For instance, during the financial crisis many banks cut their dividends, and the dividends paid by the iShares FTSE 100 ETF dropped as a result. In May 2008, it paid a dividend of 7.9p, which fell to just 5.5p in May 2009. And last year, Vodafone (VOD) paid a very large special dividend which caused a spike in May 2013's dividend (8.5p), which then fell back to7.5p in May 2014."

Why bond ETF yields can be erratic

If you're investing in a bond ETF, bear in mind that the price will move inversely to yields. So, if the price performance of bond ETFs has been very good and as prices get higher, yields drop. For example, iShares Core £ Corporate Bond UCITS ETF (SLXX) has cut its May dividend in half (from £2.18 in May 2008 to £1.06 in May 2014) because yields have dropped, although the ETF has performed well over that period.

There is also a seasonality to bond coupon payments, according to Mr Sleep. Coupon payments are not synchronised to quarter-ends or year-ends. Some bonds pay semi-annually, while others pay annually. Unlike equity dividends, you cannot necessarily expect these to rise through time. Bond ETF yields will reflect underlying interest rates, which will go up and down over time, inversely to the price of the bonds.

Dividend payments for iShares Emerging Market Dividend ETF

Source: iShares

Choose investment trusts for a smoother ride

If you're willing to hold your investment for a number of years, you should see a steadily increasing dividend trend over time. But bear in mind that with a physical ETF or a tracker, you are getting a precise reflection of what is happening with the market, which means you'll have to put up with peaks and troughs along the way. If you're looking for a smoother ride, and a smoother income stream, an investment trust could be a better bet. This is because the portfolio manager can hold money back to smooth the trust's dividends. But, ultimately, these dividends will have to reflect both the performance of the portfolio manager and what is going on in the underlying market.

Dividend payments for Murray International

Source: FE Trustnet