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Get high income at low cost via dividend ETFs

A new range of income-focused ETFs are returning more than the average benchmark and paying out more

In an environment of low interest rates and paltry yields it is increasingly hard to find income investments at a reasonable price and without taking high risk. But a new wave of equity income exchange traded funds (ETFs) are offering a basket of high-yielding stocks for a low ongoing charge.

There are more than 36 equity income ETFs on the London Stock Exchange tracking high-dividend-paying companies, and many are outperforming standard indices while paying out more - and at lower risk. But beware the side-effects of a strong sector tilt and high concentration.

Income-focused ETFs can offer yields of around 2-3 per cent above their markets at a lower risk. But you need to know which method yours is using. Traps await investors who target high yields, but don't keep an eye on sustainability or look only to past income payers without considering the income stocks of the future.

Investors can isolate high-income stocks by focusing on:

■ Future dividend payers.

■ Past dividend payers.

■ Stocks with a high current yield.

ETFs focusing on shorter timeframes tend to come with higher returns and higher volatility, while those with long time frames reduce risk, but also income.

 

Backward-looking measures

SPDR looks back the furthest of all the ETF providers to find its group of income-paying stocks. SPDR S&P Euro Dividend Aristocrats UCITS ETF (EUDI), SPDR S&P UK Dividend Aristocrats UCITS ETF (UKDV) and SPDR S&P Global Dividend Aristocrats UCITS ETF (GLDV) track indices of companies with over 10 or 20 years of dividend increases depending on the region, weighted by dividend yield. As a result these are some of the most concentrated portfolios, but they also have a range of caps and checks to ensure the risk is kept low. They have outperformed rival products and their parent indices by a good margin. These ETFs were set up as alternatives to bonds and are designed to produce steady, long-term income.

Antoine Lesné, head of Europe, Middle East and Africa (EMEA) ETF sales strategy at SPDR, says: "Investors typically liked fixed income because there is stability in the coupon being paid and if you are looking to equities as a source of income that's what you want. We also saw that companies that have been growing their dividends over time are those that have outperformed the standard benchmark over the long term."

However, these funds are concentrated. SPDR S&P UK Dividend Aristocrats has just 30 constituents including GlaxoSmithKline (GSK), Tate & Lyle (TATE) and British American Tobacco (BATS). SPDR's US equity income ETF has the most holdings with 100.

These funds tend to come with lower yields than other income ETFs due to their focus on picking long-term payers, which makes them more conservative and defensive. However, the ETFs still offer a healthy uplift relative to the standard yields from UK, US and European markets. These SPDR funds have also substantially outperformed their home markets over the long term in total return terms.

SPDR S&P US Dividend Aristocrats has returned 15.3 per cent in one year compared with 5.2 per cent for the S&P 500 Index, and over three years it generated returns of more than 40 per cent compared with 36 per cent for the S&P 500.

But any company that has cut its dividend, even for one year only, is automatically excluded from these ETFs. That means companies that have either turned themselves around or are new to the market cannot be included in the indices they track for many years, and investors miss out on exposure to stocks such as Lloyds Banking (LLOY) in the UK.

Mark Fitzgerald, head of product, Europe at Vanguard, says: "Just think back to the BP (BP.) oil disaster when the company said it would not pay dividends for two quarters. That was one of the largest dividend payers in the UK listed equity space and, although it stopped paying dividends, in the future the dividend stream was going to be strong."

Wisdomtree, an ETF provider with a dividend focus across its range, also looks backwards but only over one year. It differs from other providers by weighting index stocks by total cash dividends paid in order to avoid overweighting stocks with tanking share prices. Its ETFs have the highest income streams.

Nizam Hamid, ETF strategist at WisdomTree, says: "Looking over one year means that as you go through the cycle, and companies either cut or reinstate their dividend, you have the ability to reintroduce companies to the index rather than banning them for 10 years."

WisdomTree US Equity Income UCITS ETF (DHS), WisdomTree Europe Equity Income UCITS ETF (EEI), WisdomTree UK Equity Income UCITS ETF (WUKD) and its related emerging markets and Asia ETFs take stocks from the same universe of European, Far East Asian and Australasian companies. Stocks are then ranked by dividend yield, with the top 33 per cent from each market making the next stage. Unlike other indices stocks are not weighted by market capitalisation but by cash dividends paid. "If you had a large company paying a large-cap dividend it would have a higher weighting in the index, whereas a very high-yielding small company with an unsustainable payout would be excluded because in absolute terms the yield would still be low," explains Mr Hamid.

 

Future dividend payers

Vanguard does not pay any attention to previous dividend payers and weights stocks only by forecast dividend yield. Vanguard FTSE All-World High Dividend Yield UCITS ETF (VHYD) is the company's only dividend-focused product available on the London Stock Exchange and it tracks one of the most populated indices, which has over 1,000 stocks. The index screens for stocks from the FTSE All-World Index with a higher than average dividend yield, and then ranks them by dividend yield until the cumulative market capitalisation reaches 50 per cent of the total universe of stocks.

The ETF has underperformed the FTSE All-World Index but delivered a far higher income historically. Its current yield is just under 4 per cent, compared with 2.64 per cent for FTSE All-World. But it is riskier and concentrated: its top 10 stocks account for 16.15 per cent of its assets compared with just 8.5 per cent for FTSE All-World Index.

db x-trackers equity income ETFs have some of the most concentrated portfolios with just 30 holdings in db X-trackers EURO Stoxx Select Dividend 30 UCITS ETF (XD3E) and 100 in db X-trackers Stoxx Global Select Dividend 100 UCITS ETF (XGSD). These indices take only the highest-yielding stocks from their chosen regions.

iShares uses a range of dividend strategies in its London-listed ETFs. iShares EURO Dividend ETF(IDVY) provides diversified exposure to the 30 highest-yielding eurozone companies that have passed a number of dividend sustainability screens. iShares MSCI USA Dividend IQ UCITS ETF (QDIV) applies quality screens and reviews 12-month past performance to omit stocks with potentially deteriorating fundamentals, which could cause them to cut or reduce dividends.

However, iShares UK Dividend UCITS ETF (IUKD) is a narrow strategy focusing only on the 50 stocks with leading dividends in the past year.

 

When income strategies underperform

The side-effect of choosing only income-paying stocks is that you tend to end up with a portfolio slanted towards sectors that will underperform in rising markets. Stocks that act like bonds - particularly the consumer discretionary and utility stocks which have paid out dividends for long periods - have been flooded with cash during the consistent period of low interest rates. As a result they are looking expensive, and could fall in value if markets turn and value-style investing comes back into favour.

Amanda Rebello, head of passive distribution at Deutsche Bank AM, says: "There is some evidence that over the long term dividend-weighted indices can outperform their regular non-dividend-weighted counterparts. There are periods in the short term when the high-dividend strategy may underperform, for example, if there's a major bull market and stock prices are shooting up."

 

Avoid the yield trap with quality controls

Historical yield is the most common measure used when analysing income, but it is directly related to share price and is easily distorted by falling or rising stock prices. "The big risk is that you have companies that seem to be paying a very high yield, but not because they are paying out a higher dividend but because their share prices have halved," says Wei Li, head of EMEA investment strategy for iShares.

To get around that many providers use sustainability and quality screens to vet the companies they are invested in for quality dividends. Providers such as SPDR screen the companies in their index for any that might be paying unsustainable dividends. It excludes any company with payout ratios over 100 per cent - to exclude those borrowing to pay dividends - and puts a 10 per cent cap on dividend yield.

db X-trackers MSCI North America High Dividend Yield Index UCITS ETF (XDND) excludes securities that have a dividend payout considered either extremely high - in the top 5 per cent of securities with a positive payout - or zero or negative.

A provider going even further is Lyxor. Its Quality Income ETFs track the SG European Quality Income Index family, which ranks stocks based on a quality and balance sheet risk score, as well as looking at historic dividend yield. These ETFs have lagged their home indices' total returns but have high yields.

Providers say innovation is coming in this area. "I would expect there to be more of a focus on integrating quality measures into high-dividend strategies in the coming months and years," says Ms Rebello.

Mr Fitzgerald says: "We will increasingly see a move to an emphasis on quality. Investors want an above-average yield, low portfolio turnover and low-risk, but you need to remember that the more you move towards quality, the more you have to give up yield."

Income ETFs also tend to be very concentrated on a small number of countries. The UK market is famed for its high concentration in a few high-paying names, and the same is true of these ETFs. To get around that issue many of these ETFs limit their single stock and country exposure. For example, the index the Wisdomtree UK equity income fund tracks caps single stocks at 3.3 per cent and sectors at 25 per cent, while its US equity income index caps stocks at 5 per cent and sectors at 25 per cent. Its Europe equity income index caps single stocks at 5 per cent and countries at 33 per cent.

SPDR equity income products cap US stocks at 4 per cent, European and UK stocks at 5 per cent, and global stocks at 3 per cent.

The best regions for income

The best-performing region for income-focused ETFs has been Europe, where ETFs have outperformed standard indices on a total return and yield basis. This is also the area experts feel could deliver income in the year ahead. Mr Lesné says: "The eurozone would be a good place to look for dividends because of the low yield environment. It will continue to remain attractive to investors."

In the US, dividend-focused ETFs have returned more than the S&P 500 but are yielding less. They have a short track record, though, so could turn this around in the coming years. The opposite is true of global income ETFs, which tend to underperform in terms of total returns but far exceed standard benchmarks when it comes to income.

UK ETFs deliver a far higher income but few are older than a year.

Total returns (% cumulative) and income earned on ETFs

Total return
UK income ETFsStart date1m3m6m1yr3yrIncome earned (on £100 over one year)12-month yield (%)
BMO - MSCI UK Income Leaders (ZILK) 05.11.15-0.13.10.3  £0.00na
Wisdomee - UK Equity Income UCITS ETF (WUKD)28.09.15-0.64.60.2  £1.76na
iShares - UK Dividend UCITS ETF GBP  (IUKD)04.11.05-0.75.6-2.9  £4.815.61
SPDR S&P UK Dividend Aristocrats UCITS ETF (UKDV)28.02.120.03.90.3-8.87.7£1.364.52
Source FTSE Rafi UK Equity income (DVUK)03.03.16-0.2    £0.00na
FTSE 100 0.65.50.9-7.45.1 3.7

 

Global income ETFs Start date1m3m6m1yr3yr5yrIncome earned (on £100 over one year)12-month yield (%)
DB X-trackers - Stoxx Global Select Dividend 100 UCITS ETF 1D EUR (XGSD)01.06.07-2.61.07.01.915.640.2£4.223.24
Lyxor ETF SG Global Quality Income (SGQL)01.01.14-0.50.66.84.112.0 £5.634.39
Vanguard - FTSE All World High Dividend Yield UCITS USD (VHYD)21.05.13-2.12.43.7-3.010.1 £3.513.28
SPDR S&P Global Dividend Aristocrats UCITS ETF (GLDV)14.05.13-3.33.85.3-3.014.0 £7.182.52
UBS - (Irl) ETF plc - DJ Global Select Dividend UCITS ETF (USD) A Dis  (UC75)04.09.14-2.82.45.5-3.5  £6.374.38**
MSCI World  -1.12.42.30.422.655.7 2.65
FTSE All-World  0.54.43.5-0.622.151.2 2.64

US income ETFsStart date 1m3m6m1yr3yr5yrIncome earned (on £100 over one year)12-month yield (%)
DB X-trackers - MSCI North America High Dividend Yield Index UCITS ETF (DR) 1C (XDND) 29.01.14-0.41.99.411.0  -0.00
WisdomTree US Equity Income UCITS ETF (DHS)21.10.14-0.32.011.511.3  £3.292.74
iShares - MSCI USA Dividend IQ UCITS ETF NAV GBP  (QDIV) 06.06.14-0.31.28.611.6  £2.661.20
SPDR S&P US Dividend Aristocrats UCITS ETF (USDV)14.10.11-0.63.012.414.238.5 £2.451.98
UBS - ETF Factor MSCI USA Total Shareholder UCITS ETF (USD) A Dis (UD01) 26.08.15-1.01.54.8   £1.24na
Source FTSE Rafi US Equity Income (DVUS)29.02.16-1.4     £0na
Powershares S&P 500 High Dividend Low Volatility UCITS ETF (HDLG) 11.05.15-2.20.713.917.7  -2.85**
S&P 500  -0.551.713.545.7236.5989.33 2.2

Europe income ETFs Start date 1m3m6m1yr3yr5yrIncome earned (on £100 over one year)12-month yield (%)
DB X-trackers - EURO Stoxx Select Dividend 30 UCITS ETF (DR) 1D EUR (XD3E)01.06.070.25.76.06.023.019.5£3.453.30
BMO - MSCI Europe ex-UK Income Leaders (ZILE)05.11.150.84.62.5   £0.00na
WisdomTree Europe Equity Income UCITS ETF (EEI)21.10.14-0.34.50.6-7.2  £1.964.66
iShares - EURO Dividend UCITS ETF EUR  (IDVY)28.10.050.55.56.26.023.420.2£1.784.02
SPDR S&P Euro Dividend Aristocrats UCITS ETF (EUDI)28.02.12-0.34.27.42.411.6 £0.343.04
UBS - ETF - Factor MSCI EMU Total Shareholder Yield UCITS ETF (EUR) A Dis (UD05)18.08.158.243.8410.89   £0.31na
Lyxor - UCITS ETF SG European Quality Income N D  (SGQG)19.08.130.31.50.3-6.6  £0.004.65
MSCI Europe  0.33.80.2-5.48.824.4 3.65
MSCI EMU -0.24.1-1.0-4.110.617.9 3.37

Source: Total return and income earned, FE Analytics, as at 27.05.16. ** Thomson Reuters and/or Datastream. Yield data Morningstar, as at 27.04.16. The sum of a fund's total trailing 12-month dividend payments divided by the last month's ending share price (NAV) eliminating the interest and capital gains traditionally reported within 12 month figures.

Equity income ETFs listed on London Stock Exchange

US
DB X-trackers MSCI North America High Dividend Yield Index UCITS ETF (XDND) 
WisdomTree US Equity Income UCITS ETF (DHS)
iShares MSCI USA Dividend IQ UCITS ETF (QDIV) 
SPDR S&P US Dividend Aristocrats UCITS ETF (USDV)
UBS Factor MSCI USA Total Shareholder UCITS ETF (UD01) 
Source FTSE Rafi US Equity Income (DVUS)
EUROPE 
db X-trackers EURO Stoxx Select Dividend 30 UCITS ETF (XD3E)
BMO MSCI Europe ex-UK Income Leaders (ZILE)
WisdomTree Europe Equity Income UCITS ETF (EEI)
Lyxor UCITS ETF PEA Euro Stoxx 50 Dividends (EDIV)
iShares EURO Dividend UCITS ETF (IDVY)
SPDR S&P Euro Dividend Aristocrats UCITS ETF (EUDI)
UBS Factor MSCI EMU Total Shareholder Yield UCITS ETF (UD05)
Lyxor SG European Quality Income NTR UCITS ETF (SGQE)
UK
BMO MSCI UK Income Leaders (ZILK) 
Wisdomtree UK Equity Income UCITS ETF (WUKD)
iShares UK Dividend UCITS ETF (IUKD)
SPDR S&P UK Dividend Aristocrats UCITS ETF (UKDV)
Source FTSE Rafi UK Equity Income (DVUK)
GLOBAL 
db X-trackers Stoxx Global Select Dividend 100 UCITS ETF (XGSD)
Lyxor ETF SG Global Quality Income (SGQL)
Vanguard - FTSE All World High Dividend Yield UCITS USD (VHYD)
SPDR S&P Global Dividend Aristocrats UCITS ETF (GLDV)
UBS Global Select Dividend UCITS ETF (UC75)

Source: London Stock Exchange