US exchange traded fund (ETF) provider WisdomTree has recently entered the UK with the launch of four income funds on the London Stock Exchange. WisdomTree Europe Equity Income UCITS ETF (EEI), WisdomTree Europe SmallCap Dividend UCITS ETF (DFE), WisdomTree US Equity Income UCITS ETF (DHS) and WisdomTree US SmallCap Dividend UCITS ETF (DESE) use physical replication - buy shares in the indices they track.
| Fund | Total expense ratio (%) | Index dividend yield (%) |
| WisdomTree Europe Equity Income UCITS ETF | 0.29 | 5.7 |
| WisdomTree Europe SmallCap Dividend UCITS ETF | 0.38 | 3.9 |
| WisdomTree US Equity Income UCITS ETF | 0.29 | 3.6 |
| WisdomTree US SmallCap Dividend UCITS ETF | 0.38 | 3.6 |
Source: WisdomTree
They join a growing number of equity income ETFs listed in London, such as IC Top 50 ETFs SPDR S&P US Dividend Aristocrats UCITS ETF (USDV) and iShares UK Dividend UCITS ETF (IUKD). This gives investors more choice but also means you need to ensure you to pick the right fund for what you want to achieve.
Dividend strategy ETFs track various indices using different methodologies, and this is a crucial factor in what the ETF is going to return.
"ETFs put in place certain risk controls which try to avoid some of the pitfalls of passive investing like buying shares that are too small and illiquid, buying a share that is about to go bust, buying a company that is about to cut its dividend or putting together an ETF investment that is concentrated in a few sectors," says Peter Sleep, senior portfolio manager at Seven Investment Management. "As a result, the dividend ETFs differ in the way they weight stocks."
WisdomTree, for example, weights the stocks by looking at the cash dividend paid in the past year looking at the top 25 or 30 per cent per cent of dividend payers.
The simplest approach is to select and weigh stocks by one year forecast dividend yield without a quality screen. This methodology is used by ETFs such as iShares UK Dividend UCITS ETF and iShares Asia Pacific Dividend UCITS ETF (IAPD).
Other approaches introduce additional screening criteria such as dividend growth, payout ratio and positive earnings. Shares in the S&P High Yield Dividend Aristocrats Index must have increased their dividend for at least 20 consecutive years as this index seeks holdings with a record of consistency of dividend growth rather than focusing only on the highest yielding stocks.
Meanwhile, iShares MSCI USA Dividend IQ ETF (QDIV) and db X-trackers MSCI North America High Dividend Yield Index UCITS ETF (XDND) track indices where stocks must have higher than average dividend yields, track records for consistently paying dividends and the capacity to sustain dividend payments.
"iShares hopes to launch a full range of Dividend IQ ETFs in due course," says Mr Sleep. "This strategy seeks to weed out those high dividend paying stocks that are not growing and are at risk of cutting their dividend, while moderating volatility and a high dividend."
This ETF only launched in June, however, so does not have a long track record.
Alan Miller, founding partner and chief investment officer of wealth manager SCM Private, says when choosing an ETF it is important that you understand the underlying index and how it selects its holdings. You should also consider if the largest companies in it are ones that you really want to hold, and if you like the geographic exposure.
"There is no substitute for reading a fund's methodology document," says Hortense Bioy, director of passive fund research in Europe at Morningstar. "Differences in sector weightings and portfolio composition can cause their performance to diverge. Understanding a fund's process can help to better understand how it will likely perform in different market environments and set realistic expectations."
She prefers dividend ETFs with robust quality screens such as track records for consistently paying dividends and the capacity to sustain dividend payments. For US exposure she says examples include SPDR S&P US Dividend Aristocrats UCITS ETF, iShares MSCI USA Dividend IQ ETF and db x-trackers MSCI North America High Dividend Yield ETF.
But because some quality screened funds require long periods of consecutive growth, they could miss out on new high-quality dividend payers. And some dividend ETFs can also exhibit high concentration in sectors such as financials, utilities, and defensives.
A problem for all dividend-paying stocks is a potential increase in interest rates. "Dividend paying stocks tend to outperform in stable or declining rate environments but struggle when rates are on an upswing," says Ms Bioy. "When rates rise, a company's cash flow must be discounted at a higher rate. All stocks are affected, but if the economy is booming, stable dividend paying stocks don't generate as much investor demand as riskier stocks from cyclical and speculative sectors. When rates rise because the economy is growing at a healthy clip, defensive sector stocks in particular become an expensive trade."
Mr Miller argues that you should focus on ETFs which invest in an attractive asset area, with a sensible yield (over 3 per cent) but of which the holdings do not have a demanding price-earnings ratio (PE) or very little growth. "The valuations of property stocks and property ETFs are fairly insane in my view so I would avoid these," he says. "I would also avoid the US share ones as these valuations are also full.
"The only ones that look interesting to my mind are the two emerging market dividend ETFs, iShares Emerging Markets Dividend UCITS ETF (SEDY) but in particular SPDR S&P Emerging Markets Dividend UCITS ETF (EMDV), which tracks a well spread index of 117 stocks with a low PE of 10x."
He suggests looking at the underlying constituents, their prospects and valuation rather than just the yield or fund name. "Shares with high yields tend to have either very low growth prospects (if any) and can be susceptible to dividend cuts as they are often financially unstable. Often what you gain in income you lose in capital so we tend to avoid them as we believe you should look to maximise the total return."
Other things you should consider when choosing a dividend ETF include its tracking difference and its ongoing charges.
